How to Calculate the Acid Test Ratio (And Why It Matters)

Do you know what the acid test ratio is? Also known as the quick ratio, this liquidity metric measures how well a company can cover its short-term liabilities with its short-term assets. In this guide, we’ll break down how to calculate the ratio step by step, and discuss its implications for business owners. Keep reading to learn more!

Some Background

What Is The Acid Test Ratio?

The acid test ratio, also known as the Quick Ratio, is a liquidity ratio that measures how sufficient a company’s short-term assets are to cover its current liabilities. In other words, the ratio is a measure of how well a company can satisfy its short-term (current) financial obligations.

There are two types of acid test ratios:

– The gross acid test ratio, which includes inventory in its calculation of short-term assets.

– The net acid test ratio, which excludes inventory from its calculation of short-term assets

For the purposes of this guide, we will focus on the net ratio since inventories are most often excluded.

What Does It Mean To Me?

The acid test ratio is important because it is a metric that creditors and investors look at to assess a company’s financial health. A low ratio may indicate to creditors and investors that the company is having difficulty meeting its short-term obligations, which could lead to difficulties in obtaining future financing. As an investor, a low ratio could mean that the company won’t be able to pay dividends (which require cash) or ultimately return your investment.

Note that too high of a ratio isn’t necessarily good either. A high ratio may mean that the company has too much cash on hand, and they aren’t finding good investments for that cash. It could also mean they aren’t returning enough to shareholders.

Formulas And Other Fun Stuff

How To Calculate The Acid Test Ratio

Here is the formula to calculate this ratio:

The following items can all be found on a company’s balance sheet:

Cash and cash equivalents are the most liquid current assets on a company’s balance sheet and include checking accounts, saving accounts, or term deposits/bonds with less than a 3-month maturity
Marketable securities are financial instruments that can be readily converted into cash
Accounts receivables are the amounts owed to a company for providing customers with goods or services.
Current liabilities are debts or obligations due within one year.

Finding Information To Calculate Ratios

If you are working internally for your own company, the financial systems will have all of this information for easy calculations. You may even be able to build these types of ratios right in the system.

To find information externally, you can go straight to the company’s website and look for its SEC filings. You can also use a financial database, like Morningstar, Yahoo! Finance, Seeking Alpha, or Motley Fool.

Let’s Walk Through An Example

First, we need to visit a company’s investor page or access a financial database. For more information on finding investor pages, visit our article on Reading Financial Statements.

For this example, we will use General Motors which was the 22nd largest company in the US for 2021. This is a great example as they run a large accounts receivable balance as they produce cars to sell to dealerships. You can find General Motors SEC filings on their investor website.

Let’s look at the 3rd Quarter 2021 filing, the most recent quarterly filing available. Here are the asset and liabilities sections of the balance sheet that we need:

Now that we have the data, let’s plug it into our formula.

Acid test ratio for General Motors Q3 2021

General Motors has an acid test or quick ratio of 0.88 which on first glance means they cant cover all of their current assets. This is where understanding the industry is important. The gap between current assets and liabilities is driven by the financing portfolio which doesn’t have the same term or payment policies as the rest of the assets and liabilities. Excluding financing, the quick ratio moves easily above 1.0.

Let’s Recap

Now that you understand the ratio and how to calculate it, you can start using this metric to assess the financial health of companies.

Frequently Asked Questions

What Are The Limitations Of The Acid Test Ratio?

The acid test ratio alone is not sufficient to determine the liquidity position of the company. Other liquidity ratios such as the current ratio or cash flow ratio are commonly used in conjunction with the acid test ratio to provide a more complete and accurate estimation of a company’s liquidity position.

What Is The Difference Between The Quick Ratio And The Acid Test Ratio?

There isn’t a difference! They are two names for the same ratio.

What Is A Bad Acid Test Ratio?

A “bad” ratio depends on the industry. You can compare a company’s ratio to its competitors to see how it stacks up. Generally, a ratio of less than 1 is a cause for concern in any industry.

What Does It Mean If A Company Has A High Acid Test Ratio?

A high ratio may mean that the company has too much cash on hand. It could also mean they aren’t finding good investments for that cash. It could also mean they aren’t returning enough to shareholders.

Are There Other Ratios I Should Know For Short-Term Assets?

One of the best ratios for short-term assets is the Accounts Receivable to Sales Ratio. The Accounts Receivable to Sales Ratio is an important metric that can provide insight into the financial health of your business. It measures how quickly customers pay their invoices and indicates how much cash flow is available for operations.

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