LIQUIDITY RATIOS

Acid Test Ratio (Quick Ratio/Liquid Capital Ratio)Tweet

Firms often need to borrow money to invest in the business and help it grow. Debts are not a problem as long as they are managed properly. The Acid test ratio is one of the calculations that can be used to find out if a firm is borrowing money sensibly. The Acid test ratio looks at whether a firm has enough current assets to pay back its short term debt (current liabilities). Stock (inventory) can not always be converted into cash quickly. Inventory can “go out of date”, get damaged or lose value, so the acid test ratio shows you how many times the business can pay off its current liabilities, if stock is not included as a current asset.

Acid Test Ratio              Current Assets - Stock
                        =          __________________           

                                    Current Liabilities

Example

For example if my current assets are £9000 which includes £3000 of stock and my current liabilities are £2000 I would work out my current ratio as follows

Current Assets - Stock                       9000 – 3000                6000
_________________              =          _________      =          _____  = 3

Current Liabilities                                2000                            2000

As Liquidity ratios are expressed against 1 my acid test ratio for this example is 3:1. In this example I can use my current assets to pay off my current liabilities three times. In other words my current assets are three times the size of my current liabilities. The Current Asset Ratio carries out a similar calculation to the Acid Test Ratio but it includes inventory as a current asset.