Consequently, the ratio is commonly used to evaluate businesses in industries that use large amounts of inventory, such as the retail and manufacturing sectors. These items may not be convertible into cash for some time, and so should not be compared to current liabilities. The ratio is most useful in those situations in which there are some assets that have uncertain liquidity, such as inventory. In this case, it might make more sense to pay the excess assets to investors in the form of a dividend or a stock buyback. In this case, a business is sitting on an excessive amount of liquid assets that it cannot use. However, even with such a favorable ratio, it is possible that timing differences will exist, such as a large liability that is due for payment within the next few days, while the offsetting assets may not be liquidated for another few weeks.Īnother issue is when an extremely high ratio exists, such as anything over 5:1. This is also the case when there is a wealthy investor that is willing to invest more cash in the business, as needed.Ī better proportion for the ratio is 2:1, which generally indicates enough liquidity to settle all obligations. However, if a business has a line of credit that it can drawn down to pay off any obligations as they come due, then even a low ratio may not be a valid indicator of payment problems. When the acid-test ratio reveals a ratio of 1:1 or worse, it indicates that a business could be at significant risk of not being able to pay its liabilities as they come due. The Interpretation of Financial Statements Only then will the ratio yield a true interpretation of company liquidity. Also, do not include inventory in the calculation, since it can take a long time (if ever) to convert inventory into cash. Similarly, if you are aware of any accounts receivable that are not expected to be collected on time, then consider excluding them from the calculation. For example, if cash or marketable securities are restricted from use, then do not include them in the calculation. The intent behind using this ratio is to examine the liquidity of a business, so be sure to exclude from the cash, marketable securities, and accounts receivable figures any assets that cannot be accessed. (Cash + Marketable securities + Accounts receivable) ÷ Current liabilities = Acid test ratio The formula for the acid-test ratio is as follows: The current liabilities figure is stated as a subtotal on the balance sheet. All of this information is stated in separate line items on a firm’s balance sheet. To calculate an organization’s acid test ratio, add together its cash, marketable securities and accounts receivable, and then divide by the total amount of current liabilities. Investors may also use it to discern whether a business has so much excess cash that it can afford to issue a dividend to them. It is commonly used by creditors and lenders to evaluate their customers and borrowers, respectively. If not, there is a significant risk of default. The intent of this ratio is to evaluate whether a business has sufficient cash to pay for its immediate obligations. The acid-test ratio compares a company’s most short-term assets to its short-term liabilities.
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