How would your business cope with a sudden liquidity crisis? Are your assets liquid enough to provide you with the cash influx you need to weather a potential storm? These are the questions that the acid test ratio helps small businesses answer. But what is the acid test ratio? Find out everything you need to know about the acid test ratio formula with our simple guide.
What is the acid test ratio?
The acid test ratio, also referred to as the quick ratio, is a liquidity ratio that measures your company’s ability to pay off its current liabilities with its quick assets. Quick assets is a term describing current assets that can be converted to cash within the space of 90 days (this includes items like accounts receivable, cash, cash equivalents, short-term investments, and marketable securities). Ultimately, the acid test ratio is an excellent way to gauge your firm’s short-term liquidity,
How does the acid test ratio formula work?
To calculate the acid test ratio, you’ll need to use the acid test ratio formula, which is as follows:
Acid Test Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
The acid test ratio formula is sometimes expressed, more simply, like so:
Acid Test Ratio = Liquid Assets / Current Liabilities
Understanding how acid test ratio interpretations work in practice should be fairly straightforward, but to help you out, let’s look at an example. Assume that Company A’s books show the following figures:
Current liabilities - $100,000
Short-term investments - $45,000
Accounts receivable - $25,000
Cash and cash equivalents - $60,000
Using the acid test ratio formula, you can determine their liquidity like so:
($45,000 + $60,000 + $25,000) / $100,000 = 1.3
In other words, you have an acid test ratio of 1.3:1. This means that you have $1.30 of liquidity for every $1 of short-term debt. That’s a good thing, indicating that Company A is liquid enough to deal with any liquidity problems, should they arise.
What is an acceptable acid test ratio?
Although the acceptable acid test ratio range is dependent on industry, usually, an acid test ratio of 1:1 is considered normal. In most cases, a ratio of <1 is not considered an acceptable acid test ratio, as it indicates that the company will not be able to pay back its current liabilities in full. Generally, a high acid test ratio is a strong indication of financial health. However, it may also signal that your business is too conservative when it comes to capital allocation.
What is the importance of the acid test ratio for small businesses?
Ultimately, the acid test ratio formula is an excellent means of determining whether your business can meet its short-term debt obligations without selling inventory. Consequently, you can use it to work out how your firm will cope in situations where revenue takes a sudden drop. For small businesses, the importance of the acid test ratio mostly revolves around the fact that banks use it when reviewing applications for lines of credit or small business loans.
How can you improve your firm’s acid test ratio?
If your business doesn’t have an acceptable acid test ratio, you can use a number of methods to boost your figure. Consider improving your accounts receivable processes to reduce your firm’s days sales outstanding (DSO) and ensure that less working capital is left languishing on your books. Potential strategies include allowing your customers to pay via Direct Debit, automating the overall invoicing process, and implementing airtight payment terms.
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