Definition: The Acid Test Ratio also referred to as a Quick Ratio is calculated to determine the ability of a firm to pay off its current liabilities with Quick Assets. What are Quick Assets? The quick assets are the current assets that are highly liquid and can be converted into cash within 90 days or in a short period of time.
Generally, all the current assets are the quick assets, but however, the inventory is subtracted from its value because inventories are not readily convertible into cash. The acid-test ratio is a key indicator for the investor to know if the firm is capable of paying its short-term bills on time.
Ideally, the quick ratio equal to or more than 1 is considered favorable; that shows the company is having more liquid assets and do not rely heavily on the inventories. The formula for computing the Acid-test Ratio is:
Acid-test Ratio = Quick Asset/ Current Liabilities
Higher the Acid-test Ratio, the higher is the debt-paying capacity of a firm.
Example: Suppose a firm has a cash balance of Rs 50,000, the marketable securities worth Rs 10,000, and account receivables amounting to Rs 1,00,000 (inclusive of inventories worth Rs 40,000). The current liabilities are Rs 60,000. Then the Acid test ratio will be:
Acid-test Ratio = 1,20,000/60,000 = 2:1
[Quick Asset = (50,000+10,000+1,00,000) – 60,000 = 1,20,000]