Quick Ratio (Acid-Test Ratio)

Quick Ratio (Acid-Test Ratio)

The Acid Test or Quick Ratio measures a company's ability to use its assets to retire its current liabilities immediately.

In finance, the Acid Test (also known as the quick ratio or liquid ratio) measures a company's ability to use its near-cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include current assets that presumably can be quickly converted to cash at close to their book values. A company with a Quick Ratio of less than one cannot pay back its current liabilities.

Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company's balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities, and commercial paper. Cash equivalents are distinguished from other investments through their short-term existence.

They mature within 3 months, whereas short-term investments are 12 months or less, and long-term investments are any investments that mature in excess of 12 months. Another important condition that cash equivalents need to satisfy is the investment should have an insignificant risk of change in value. Thus, common stock cannot be considered a cash equivalent, but preferred stock acquired shortly before its redemption date can be.

Cash Cash is the most liquid asset in a business.

Acid Test Ratio

Acid test often refers to Cash ratio instead of Quick ratio: Acid Test Ratio = (Current assets - Inventory) / Current liabilities.

Note that Inventory is excluded from the sum of assets in the Quick Ratio but included in the Current Ratio. Ratios are viability tests for business entities but do not give a complete picture of the business's health. A business with large Accounts Receivable that won't be paid for a long period (say 120 days), and essential business expenses and Accounts Payable that are due immediately, the Quick Ratio may look healthy when the business could actually run out of cash. In contrast, if the business has negotiated fast payment or cash from customers and long terms from suppliers, it may have a very low Quick Ratio and yet be very healthy.

The acid test ratio should be 1:1 or higher; however, this varies widely depending on the industry. The higher the ratio, the greater the company's liquidity will be (better able to meet current obligations using liquid assets).

Key Points

• Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities.
• Acid Test Ratio = (Current assets - Inventory) / Current liabilities.
• Ideally, the acid test ratio should be 1:1 or higher, however this varies widely by industry. In general, the higher the ratio, the greater the company's liquidity.

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