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Acid Test Ratio
Written by Kenny Foo   
Thursday, 12 March 2009 14:49

Investment Formula Description

Acid test ratio or acid test is a investment formula to assess company's ability to meet its debt obligations by measuring its most liquid assets.

On the other words, acid test is a stringent test that indicates whether a corporation has enough liquid assets to cover it immediate liabilities without selling its inventories. Based on formula, the inventories is deducted from current assets because inventories take some time to convert to cashes. Hence, acid test ratio is actually more strenuous than current ratio and working capital ratio. For companies that have outcome less than 1 on acid test, those companies are highly dependent on inventories. If those companies are not able to convert inventories into cash on time, they might have difficulties to pay day-to-day payments and short-term debts.

Acid test is the test that used by gold miners to test whether their findings were real gold nuggets. If the nuggets passed the acid test, the nuggets proved to be real gold. Hence, this term was used as one of the investment formula. If the corporations pass the acid test with the outcome of 1 or better, the corporations are proved to be one of the good investments with healthy liquidity. Acid test ratio is also known as quick ratio.

 

Investment Formula

Acid Test Ratio = ( Cash + Trade Receivables + Short-term investments + Fixed Deposit  ) / Current Liabilities

 

Investment Formula Examples

Corporation IJK has $12,000 cash, $8,000 trade receivables, $6,000 short-term investments,  $ 20,000 inventories and $ 10,000 fixed deposit. Besides, the current liabilities for corporation IJK is $20,000. The acid test ratio calculation is as following.

Acid Test Ratio = ( Cash + Trade Receivables + short-term investments + Fixed Deposit ) / Current Liabilities = ( 12,000 + 8,000 + 6,000 + 10,000 ) / 20,000 = 36,000 / 20,000 = 1.8

Unlike current ratio, $20,000 inventories is not accountable in acid test ratio. Corporation IJK has passed the acid test with the outcome of 1.8. This proved that corporation IJK is able to meet its debt obligations without including inventories.

 

 



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Last Updated ( Thursday, 12 March 2009 16:59 )
 
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