Acid Test Ratio: An Overview

The acid test ratio (ATR) is an important financial measure used to gauge a company’s short-term liquidity, or its ability to meet its near-term obligations. It is calculated by taking a company’s available cash and its quick assets – assets that are quickly convertible into cash – and dividing them by its current liabilities. The resulting ratio is then used to assess the business’s liquidity position.

Understanding the Acid Test Ratio

The acid test ratio is an important tool for investors, lending institutions, and other stakeholders that need to gauge a company’s ability to meet its short-term obligations. A higher ratio is better; it indicates that the company can pay its short-term liabilities with available quick assets. A lower ratio indicates that the company will not be able to meet its obligations without incurring additional debt, or by selling non-essential assets.

The acid test ratio takes into account a company’s availability of quick assets, such as cash, short-term investments, accounts receivable and inventory. On the other side, it considers only the most short-term liabilities, such as accounts payable, current portion of long-term debt, and current taxes. By only using these two factors, the acid test ratio is able to give an accurate picture of a company’s liquidity, without too much bookkeeping and theory.

Calculating the Acid Test Ratio

The acid test ratio is calculated by taking a company’s quick assets and dividing them by its current liabilities. Here’s an example formula:

ATR = (Cash + Short-term investments + Accounts receivable + Inventory) ÷ (Accounts payable + Current portion of long-term debt + Current taxes)

A company’s quick assets are added together and then divided by its current liabilities. For example, let’s say a company has $50,000 in cash, $30,000 in short-term investments, and $40,000 in accounts receivable, and $20,000 in inventory. Its current liabilities consist of $20,000 in accounts payable, $10,000 in current portion of long-term debt, and $15,000 in taxes. The acid test ratio for this company would be:

ATR = ($50,000 + $30,000 + $40,000 + $20,000) ÷ ($20,000 + $10,000 + $15,000)

ATR = $140,000 ÷ $45,000

ATR = 3.11

Conclusion

The acid test ratio is a useful tool for investors, lenders, and other stakeholders who need to quickly gauge a company’s short-term liquidity. The higher the ratio, the more liquidity the company has. As such, it’s important that lenders, investors, and business owners take the time to understand this ratio so they can make informed decisions about their investments and business operations.