What is Acid Test Ratio? Calculation and Importance

By Advisorymandi
14-December-2018 12:21:41 PM
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Many companies borrow money with the sole objective of growing the business.  Debts are not a very big issue as long as they are managed properly. Managing the cash flow of a company is extremely essential to run the daily business operations efficiently. It is imperative that the businesses must make it a point to pay off the debt at the right or due time. The total current assets of a company are one of the best ways to ensure whether the company is in a position to repay the short-term debt (current liabilities) or not. Now, the question pops out here is how to determine the current assets of a business? This can be done by calculating the acid test ratio? Let us know what it is and importance in great detail.

 

Acid Test Ratio Definition

Acid test ratio, also known as the quick ratio reflects the financial strength of a company. It is actually a measure of the ability of a company to pay off its liabilities using the quick assets. In simple terms, the ratio helps to examine how fast a company can sell or liquidate the assets to pay off the liabilities. The quick assets are essentially the current assets that are considered to be highly liquid i.e. can be easily converted into cash within 90 days. Banks and Non-Banking Financial Companies (NBFCs) take into an account this ratio to determine the short-term solvency of a company before lending.

 

How to Calculate the Acid Test Ratio?

There is a simple formula to calculate the acid test ratio of a company, which is:

Acid Test Ratio = Quick Assets / Current Liabilities

Here, the components of the quick assets and current liabilities are:

 

Quick/Liquid Assets Current Liabilities
Cash in hand Outstanding expenses
Cash at bank Bills payable
Bills receivables Sundry creditors
Sundry debtors Short-term advances
Marketable securities Income tax payable
Temporary investments Dividends payable
  Bank overdraft

 

For example, an organization has liquid assets of Rs 3, 00,000 and current liabilities of Rs 1, 00,000, the acid test ratio will be calculated as:

Acid Test Ratio = 3, 00,000 / 1, 00,000 = 3

 

Importance of Acid Test Ratio

It is important that a company must have a sufficient cash in hand in order to meet their expenses and pay bills on time. Generally, a high acid test ratio implies that the financial health of the company is good and able to meet the short-term current liabilities on time. On the other hand, a low quick ratio suggests that the company’s liquidity position is not satisfactory and may struggle to grow sales or pay bills on time. All in all, it is absolutely vital for a company to maintain a healthy liquid ratio as it will only increase their market sentiment among the investors. Similarly, a good ratio will increase its creditworthiness, which implies that the banks or creditors will have no issues at all to offer loans to the company.

 

What is a Good Acid Test Ratio?

Generally, an acid test ratio of 1:1 is considered as quite satisfactory by the creditors. It mainly signifies that the quick assets of a company are equal to its current assets. Furthermore, a liquid ratio of 2 or 3 is considered to be quite excellent as it implies that a company can use its current assets to pay off the current liabilities two or three times. It is in the best interest of an organization to have a high acid test ratio because it signifies strong financial health and the investors usually like to invest in these companies.

 

How to Improve Acid Test Ratio?

If a company wants to improve the acid test ratio, then it has to do two things, which are:

  • Increasing Sales: A company must focus on increasing its sales as this will eventually improve the cash in hand of the company. Cash is considered as a liquid asset and it will be quite excellent for the company to devote more attention towards improving sales. If more cash is there, then the company may not experience any problems to meet its short-term financial requirements.
  • Timely Payment of Liabilities: A company must make it a point to keep their liabilities or expenses under control. If the liabilities are on the lower side, then the company will be a much better position to repay the business loans and most importantly improve its market sentiment.

 

Bottom Line

An acid test ratio is an excellent indicator of the financial health of the company that helps to assess its short-term financial position. If a company wants to improve its liquid ratio and want that the people invest in shares, then monitoring the acid test ratio is extremely important.

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Author: Advisorymandi

AdvisoryMandi is India's most trusted Stock Market Advisory marketplace covers NSE, BSE, MCX & NCDEX. Invest with confidence and harness the power of AdvisoryMandi to make smarter investment decisions in Stocks, Indices, Commodities, Forex & IPO.

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