ACID TEST: WHAT IT IS FOR, HOW IT IS CALCULATED AND EXAMPLE - DUDAS - 2024

The acid test indicator is a very strong ratio or reason for knowing whether a company has enough short-term liquid assets to cover its immediate obligations or debts. It is stronger than the current ratio, also known as an indicator of working capital, since it ignores less liquid assets, such as inventory.

The acid test compares most short-term assets with short-term liabilities. The intention of this indicator is to assess whether a company has enough cash to pay its immediate obligations. Otherwise, there is a significant risk of default.

The ratio is most useful in situations where there are certain assets that have uncertain liquidity, such as inventory. Inventory items may not be able to be converted to cash for a time, so they should not be compared to current liabilities.

Consequently, the relationship is commonly used to evaluate businesses in industries that use large amounts of inventory, such as the retail and manufacturing sectors.

What is it for?

The acid test ratio is an indicator that shows how well a company can meet its short-term financial obligations.

The acid test is a more conservative version of other well-known liquidity indicators: current ratio and working capital.

Although similar, the acid test ratio provides a more rigorous assessment of a company's ability to pay its current liabilities.

It does this by eliminating all current assets from consideration, except the most liquid. Inventory is the most notable exclusion, because it is not as quickly convertible to cash and is often sold on credit.

If the acid test ratio is much lower than the working capital indicator, it means that current assets are highly dependent on inventory.

However, this is not a bad sign in all cases, as some business models are largely dependent on inventory. For example, retail stores can have a very low acid test ratio without necessarily being compromised.

Value greater than 1 of the indicator

When the acid test indicator is high (greater than 1) or rising it generally indicates that the company is experiencing solid growth, rapidly converting accounts receivable to cash and being able to easily pay its financial obligations.

Such companies typically have faster cash conversion and inventory turnover cycles.

The higher the ratio, the more financially secure a company in the short term. A common rule of thumb is that companies with an acid test greater than 1 are sufficiently capable of meeting their short-term obligations.

Obviously, it is vital that a business has enough cash on hand to meet accounts payable, interest expense, and other bills when due.

However, a very high ratio is not always good. It could indicate that the cash has accumulated and is idle rather than being reinvested, returned to shareholders, or used productively.

Indicator value less than 1

Companies with an acid test of less than 1 do not have enough liquid assets to pay their current liabilities. They must be treated with caution.

In general, low or declining acid test ratios generally suggest that a company is over-leveraged, struggling to maintain or increase sales, pays invoices too quickly, or collects too slowly.

Ideally, a company should have an acid test ratio of at least 1: 1. A company with an acid test ratio of less than 1: 1 will need to convert assets to cash more quickly.

How is it calculated?

The acid test is also known as a quick relationship. It is calculated with the following formula:

(Cash + accounts receivable + short-term investments) / current liabilities

Calculation of the numerator

The numerator of the acid test indicator can be defined in several ways. The main consideration should be to get a true picture of the company's liquid assets.

Definitely include cash and cash equivalents, as well as short-term investments, such as marketable securities. Accounts receivable are generally included, but this is not always appropriate.

For example, in the construction industry, accounts receivable can take a long time to recover. Their inclusion could make the financial position of the company appear much more secure than it actually is.

Another way to calculate the numerator is to take all current assets and subtract illiquid assets.

Therefore, inventory and other items that appear as assets on the balance sheet (advances to suppliers, prepayments, deferred tax assets) must be subtracted, if they cannot be used to pay short-term liabilities.

Calculation of the denominator

The denominator should include all current liabilities, which are debts and obligations that mature within one year.

It is important to note that time is not taken into account in the acid test indicator.

If a company's accounts payable are about to expire, but the accounts receivable is not going to be recovered for a long time, that company could be on much shakier ground than the gauge shows. The reverse can also be true.

Example

The acid test ratio of a company can be calculated using its balance sheet.

Below is an abridged version of Apple Inc.'s balance sheet for the fiscal year ending September 2017. The components of the company's current assets and liabilities are shown (all figures in millions of dollars):

First, the company's current liquid assets are obtained, adding: cash and cash equivalents, short-term marketable securities, accounts receivable and non-commercial accounts receivable.

These current liquid assets are then divided by the total current liabilities to calculate the acid test ratio.

Apple's acid test ratio =

(20 289 + 53 892 + 17 874 + 17 799) / 100 814 = 1.09

Not everyone calculates this ratio in the same way. For example, Reuters reported an acid test of 1.23 for this same quarter from Apple. This is because they only excluded inventories of total current liquid assets.

References

1. Investopedia (2018). Acid-Test Ratio. Taken from: investopedia.com.
2. Steven Bragg (2018). Acid-test ratio. Accounting Tools. Taken from: accountingtools.com.
3. BDC (2018). Acid-test ratio. Taken from: bdc.ca.
4. InvestingAnswers (2018). Acid-Test Ratio. Taken from: investinganswers.com.
5. Harold Averkamp (2018). What is the acid test ratio? Accounting Coach. Taken from: accountingcoach.com.