What Is Acid-Test Ratio? (With How To Calculate It)

When a company applies for a loan, the bank verifies whether it has sufficient current assets to pay its current liabilities or debts. Often, these banking professionals refer to the balance sheet and use figures to calculate the acid-test or quick ratio. Knowing more about this ratio can help you to understand a company's financial health. In this article, we discuss what the acid-test ratio is, review the formula, explore the steps to calculate it and learn how to interpret its result, discover pros and cons and see some examples.

What Is The Acid-Test Ratio?

The acid-test ratio (ATR) is a liquidity ratio that measures a company's ability to pay off its short-term liabilities with assets that it can liquidate. The ratio does not consider the company's inventory, but instead considers the most liquid assets available to a company, or those that are convertible to cash within 90 days. A higher ratio shows that a company is financially healthy and can pay its current liabilities. A lower ratio shows a company might struggle to pay its debts.

Related: What Is A Liquidity Ratio? (Definition, Types And Example)

Formula For Calculating The Acid-Test Ratio

The formula for calculating ATR is:

ATR = (cash & cash equivalents + accounts receivable + marketable securities) / current liabilities

You can find all these items on the balance sheet of a company. Here is a further explanation of each:

• Cash and cash equivalents: These are assets that are easily convertible into cash. This includes items such as savings accounts or term deposits with maturity.

• Accounts receivable: Accounts receivable is the money owed to a company for providing customers with goods and services. It primarily includes outstanding invoices or money owed by customers.

• Marketable securities: Marketable securities or short-term liquid securities are easily convertible assets to cash. This primarily includes government bonds, common stocks and certificates of deposit.

• Current liabilities: Current liabilities are a company's obligations or debts due within a year. This might include accounts payable, accrued expenses, income taxes, wages and short-term bank loans.

Related: What Are Current Liabilities? (And How To Record Them)

How To Calculate The ATR

Use these steps to calculate the ATR or quick ratio:

1. Add cash, accounts receivable and marketable securities

The first step in calculating the ATR is adding the liquidated assets, such as cash and cash equivalents. Next, add accounts receivable, which can vary depending on the company's industry. For instance, a construction company might exclude accounts receivable because they might take longer to collect, and financial professionals might omit inventory on hand, as it is unpredictable. Next, subtract assets you cannot liquidate from the total current assets.

It is essential to accurately determine these figures because incorrect calculations can make a company seem financially secure when it is not. Some other assets to exclude from the calculation are advances to suppliers, prepayments and deferred taxes, as they can provide an inaccurate overview of a company's liquidity.

Related: What Is A Tangible Asset? (Guide, Steps And Types)

2. Identify the current liabilities

Next, identify current liabilities from your balance sheet. Include only those liabilities that are due within a year. Omit other types of liabilities to avoid getting inaccurate results. After identifying your current liabilities, divide the sum obtained in step one by the liabilities amount. When calculating the ATR, a financial professional overlooks the aspect of time. This is essential because if a company has its payable due, but if it cannot recover its receivables for months, the ATR ignores the financial troubles the company might be facing.

Alternatively, if the company receives its receivables on time, but the payables are not due for some time, the ATR calculation can show that the company is performing poorly. Calculate the ATR using this formula:

ATR = (cash & cash equivalents + accounts receivable + marketable securities) / current liabilities

Related: How To Read A Balance Sheet (Components And Template)

Interpretation Of Acid-Test

The higher the ATR, the more cash and easily liquid assets a company has. It shows a financially healthy company that can pay its short-term obligations. Also, when a company has a very high ATR, a company might have too much idle cash unused. Strategically using the cash can help companies ensure a higher return on investments (ROI). A lower ATR might discourage lenders from offering financing because it involves a higher insolvency risk.

Often, companies benchmark the ATR in their industry to the industry average, which helps assess how the company performs relative to the competitors and other industry participants. An ATR between one and two shows a company has enough current assets to pay its current liabilities. An ATR of one shows that a company has adequate liquidity to pay its current liabilities when they are due. This value also shows a company's current assets are equal to current liabilities. A ratio of two shows the current assets are double the current liabilities.

Related: What Are Profitability Ratios? (With Types And Examples)

Pros And Cons Of Using ATR

Here are some pros and cons of using this ratio to help you learn more:

What are the advantages of the acid-test or quick ratio?

Some advantages of ATR are:

• Provides a clear overview of a company's liquidity

• Gives details about a company's financial condition or health

• Helps investors and bankers choose the right company for making a profitable investment

• Monitors a company's collection system

• Summarises a company's repayment ability against the current ratio

What are the disadvantages of ATR?

Some disadvantages of using ATR are:

• ATR might not provide an accurate liquidity position for the company.

• The ratio excludes inventory from calculations because inventory is not a liquid asset.

• The ratio does not give information about the timing and level of cash flows, which might be beneficial to determine a company's ability to pay its obligations.

• The ratio assumes that accounts receivables are readily available for collection, but it might not be accurate.

Related: What Is A Profit And Loss Statement? (Formulas And Examples)

ATR Calculation Examples

The following examples show how you can calculate ATR:

Example 1

Here is an example that can help you calculate ATR:

The salon shop owner wants to apply for a loan to remodel and expand the salon. The bank asks the company to submit its balance sheet to calculate the ATR. The current assets of the salon shop are:

Cash: ₹1,00,000
Accounts receivable: ₹50,000
Inventory: ₹70,000
Prepaid taxes: ₹10,500
Stock investment: ₹40,000
Current liabilities: ₹1,70,000

When calculating the ATR, the banking professional does not consider inventory and prepaid taxes. Here is how to use the formula to calculate ATR:

ATR = (cash & cash equivalents + accounts receivable + marketable securities) / current liabilities

Cash & cash equivalent = ₹1,00,000
Accounts receivable = ₹50,000
Stock investment = ₹40,000

Adding these figures, you get the numerator of the ATR formula.

= 1,00,000 + 50,000 + 40,000 = ₹1,90,000

Current liabilities = ₹1,70,000
ATR = 190000/170000 = 1.11

The ATR is acceptable because the ratio is above one, showing that the company has sufficient current assets to pay off its current liabilities without selling its long-term assets. Also, the ATR shows that the salon's current assets are higher than its current liabilities. The bank is likely to approve the loan because the company can pay off its debts while generating profit.

Related: What Is A Financial Statement? (With Importance And Types)

Example 2

Here is another example of calculating the ATR:

A bakery owner wants to apply for a loan to remodel and expand the bakery. The bank asks the company to submit its balance sheet to calculate the ATR. The balance sheet of the bakery is:

Inventory: ₹10,000
Prepaid taxes: ₹8,500
Total current assets: ₹70,000
Current liabilities: ₹60,000

When calculating the ATR, the banking professional does not consider inventory and prepaid taxes. Here is the formula for calculating ATR:

ATR = (cash & cash equivalents + accounts receivable + marketable securities) / current liabilities

*cash & cash equivalents account receivable and marketable securities = Total current assets – inventory – prepaid taxes*

= 70,000 – 10,000 – 8,500 = ₹51,500

ATR = 51,500/60,000 = 0.858

The ATR indicates the bakery has fewer current assets than current liabilities. The bank might not approve the loan because it shows that the company does not generate profit to pay off its current liabilities. Also, the bakery might sell its long-term capital assets to pay its current obligations.