An acid-test ratio is a financial metric used to determine a company's ability to pay off its debts. It is calculated by taking the value of all of the company's assets, with the exception of inventory, and dividing it by the value of its liabilities. A ratio of more than one indicates that the company could meet all of its debt obligations immediately if the situation arose. As with other ratios, the acid-test ratio is most effective when comparing companies with similar characteristics to each other.
In the process of doing business, a company must accumulate some debts along the way, often in the form of accounts payable and interest owed on loans. Of course, a successful company can make enough money through its daily operations to cover these debts should the need arise. The balance between what a company has in terms of its assets and what it owes can help determine the overall financial strength of that company. For that reason, the acid-test ratio is an excellent tool for investors when evaluating companies.
As an example of how the acid-test ratio, sometimes known as the quick ratio, is calculated, imagine that a company currently has $500,000 US Dollars (USD) in assets, in the form of cash, accounts receivable, and investment securities. At the same time, it has liabilities worth $400,000 USD. Dividing the $500,000 USD by $400,000 USD yields a ratio of 1.25. This means that, if the company suddenly had to pay all of its creditors, it could do so and still have 25 percent of its assets in reserve.
It is important to note that inventory is not included when calculating the acid-test ratio. This makes it different from a similar metric known as the current ratio, which uses the same formula, assets divided by liabilities, but includes inventory in the assets total. Many financial analysts consider the quick ratio to be a more realistic assessment of how a company could perform in a worst-case scenatio, since inventory often cannot be transferred to cash with ease.
Due to the exclusion of inventory from the formula, it is important for those studying the acid-test ratio of a company to rate it in comparison to other companies of the same ilk. For example, retail stores, who have a much higher percentage of their assets tied up in inventory, would likely have quick ratios that don't compare well to companies in industries where inventory isn't as prevalent. Finding a benchmark company in a specific industry and using its quick ratio as a basis for comparison is one way to use this metric to its best advantage.
