acid test ratio: calculation and interpretation
10.2 Analysis of Published Accounts – Liquidity Ratios
Acid Test Ratio (Quick Ratio) 📊
The acid test ratio tells us how well a company can meet its short‑term obligations using only its most liquid assets. Think of it as a quick “battery check” for a business – can it pay its bills without having to sell inventory?
$ \displaystyle \text{Acid Test Ratio} = \frac{\text{Cash} + \text{Marketable Securities} + \text{Accounts Receivable}}{\text{Current Liabilities}} $
Quick Assets = Cash + Marketable Securities + Accounts Receivable
Current Liabilities = Debts due within one year
How to Calculate – Step by Step 🧠
- Find Cash from the balance sheet.
- Add Marketable Securities (short‑term investments).
- Add Accounts Receivable (money owed by customers).
- Sum these to get Quick Assets.
- Locate Current Liabilities (e.g., accounts payable, short‑term loans).
- Divide Quick Assets by Current Liabilities.
| Item | Amount (£) |
|---|---|
| Cash | 150,000 |
| Marketable Securities | 50,000 |
| Accounts Receivable | 200,000 |
| Quick Assets | 400,000 |
| Current Liabilities | 250,000 |
| Acid Test Ratio | 1.60 |
Interpretation: 1.60 > 1, so the company can comfortably cover its short‑term debts without relying on inventory sales.
Interpretation & What It Means for the Business 🚀
- Ratio > 1 – Quick assets exceed current liabilities. The firm is in good shape to pay off debts quickly.
- Ratio = 1 – Quick assets exactly cover current liabilities. The company is just breaking even on liquidity.
- Ratio < 1 – Quick assets are less than current liabilities. The firm may need to sell inventory or find other funding to meet obligations.
Remember: the acid test is stricter than the current ratio because it excludes inventory, which may not be sold quickly.
• Always exclude inventory when calculating the acid test ratio.
• Show the formula in your answer to demonstrate understanding.
• Interpret the ratio in context – what does a value of 0.8 or 1.5 tell you about the company’s liquidity?
• Use an example from the case study or a fictional company to illustrate your calculation.
Revision
Log in to practice.