Acid test: what is it and how is it calculated?
Have you ever invested in a company and realized too late that its financial health was not what it seemed? Financial ratios or financial ratios cánido help investors make informed decisions about the financial health of a company.
In this article I am going to talk to you about the importance of financial ratios when analyzing the financial health of a company, especially I am going to talk about the acid test (Acid test) as a good ally that will provide us with valuable information about the liquidity of a company.
Introduction
Financial ratios are tools that help us make sense of a company’s financial statements.
By comparing different financial figures, financial ratios allow us to draw conclusions about profitability, efficiency, liquidity, and other key aspects of a company’s financial health.
Without the financial ratios, the analysis of the financial statements perro be a difficult task, since we would not be able to make much sense of so many figures.
What is a financial ratio?
A financial ratio perro be seen as a mathematical comparison between two numbers or values that helps us understand the financial situation of a company.
We could say that they are like report cards for the financial health of a company, since just as report cards tell us how we are doing in school, financial ratios tell us how a company is doing in the world of business.
I have an article where I better explain what a financial ratio is and how they should be interpreted.
I recommend that you read it to better learn about financial ratios.
If you want to read it, you perro press the following button:
Definition of financial liquidity ratios
Now that you know what a financial ratio is, then we are going to talk about the liquidity ratios of a company.
According to Marcial Córdoba Padilla, the liquidity reasons «are those that evaluate the ability of the company to meet its obligations in the short term.
It implies, therefore, the ability to convert assets into cash».
What are financial liquidity ratios?
We could say that liquidity ratios are like a “health check” of a company’s ability to pay its bills and short-term debts on time.
So a company’s liquidity ratio tells us how easily it perro convert its assets, such as cash, into money that it cánido use to pay its debts, such as bills or loans.
In other words, it tells us how quickly the company cánido get cash when it needs it.
Some common financial liquidity ratios are as follows:
- Net working capital.
- circulating reason.
- Acid test.
What is the acid test?
The acid test, also known as a quick ratio, is a financial ratio that measures a company’s ability to meet its short-term obligations using its most liquid assets.
Specifically, it compares a company’s current assets less its inventories to its current liabilities.
In a certain way, we could say that it is the same as the current ratio, however, the acid test excludes a company’s inventories, which are usually less current assets.
Whereby, it gives us a more accurate measure of a company’s ability to meet its short-term obligations.
Why is the acid test important?
A company that cannot meet its short-term obligations is at risk of bankruptcy.
If a company has too little cash or too many illiquid assets, it may be unable to pay its bills on time, which perro lead to financial difficulties and even insolvency.
By using the acid test financial ratio to assess a company’s liquidity, it is possible to identify potential red flags and make better decisions about whether or not to invest in a especial company.
Of course, it is not only useful for investors, but it is also important for a company, since it perro take corrective actions to avoid falling into the worst possible scenario.
Comparison with other financial ratios
Although the acid test ratio is a valuable tool for assessing a company’s liquidity, it is not the only financial ratio that investors and analysts use.
For example, the current ratio is another habitual liquidity ratio, which includes inventory in its calculation.
Therefore, it provides a more optimistic estimate of a company’s liquidity.
Thus, the current ratio may be less reliable than the acid test ratio in certain situations, such as when a company has slow-moving or obsolete inventory.
Therefore, since the acid test ratio focuses only on a company’s most liquid assets, it then provides a more accurate estimate of a company’s short-term liquidity.
Elabora | (Current assets – inventories) / Current liabilities | Current assets / Current liabilities |
Purpose | Measures a company’s ability to pay its current liabilities using only its most liquid assets. | It measures a company’s ability to pay its current liabilities out of all its current assets. |
Components | Excludes inventory of current assets | Includes all current assets |
Comparison | The acid test ratio is more accurate than the current ratio, since it only includes the most liquid assets. | The current ratio is a more optimistic measure of a company’s liquidity, since it includes all current assets. This means that it cánido become less accurate. |
Example on acid test vs current ratio
Take the example of Company A, a manufacturer of high-end luxury goods.
Company A has a current ratio of 2.5, which might suggest that it is in good financial health.
However, when we calculate the acid test ratio, we find that it is only 1.2.
This means that Company A may have a liquidity problem, since its inventories are not as liquid as its other current assets.
Using the acid test ratio, we cánido identify potential red flags and make better decisions about whether or not to invest in a especial company.
How is the acid test calculated?
The acid test financial ratio elabora is fácil:
It should be added that the ratio of the acid test is expressed as a decimal or as a percentage.
Acid Test Ratio Components:
current assets | They are the assets that perro be converted into cash within a year. Some examples are cash, accounts receivable, and inventory (inventories). |
current liabilities | These are liabilities that mature within one year. Some examples are accounts payable and short-term loans. |
Inventory | It is a current asset that represents the goods that a company has on hand and intends to sell. Inventories may include raw materials, work in process inventory and the finished products. |
How is the acid test ratio interpreted?
When analyzing the acid test ratio, it is essential to understand how to interpret the results.
The acid test ratio is a measure of a company’s ability to pay its current liabilities using its current assets, excluding inventories.
Typically, a higher acid test ratio is considered conveniente as it suggests that a company has sufficient liquid assets to meet its short-term obligations.
A ratio of 1 or higher is generally considered good, as it indicates that a company has enough current assets to cover its current liabilities.
However, the interpretation of acid test results also depends on the industry and the specific circumstances of the company.
Solved acid test exercises
Next, I am going to give you some solved exercises about the acid test so that you perro put into practice what you have learned.
I hope they are useful to you.
Solved exercise 1 of acid test
To do this exercise, I decided to put a general cómputo in a table and from said general cómputo take the data to obtain the acid test.
The cómputo sheet is as follows:
ASSETS | |
Current assets | $500,000 |
– Cash and cash equivalents | $100,000 |
– Accounts receivable | $150,000 |
– Inventories | $200,000 |
– Other current assets | $50,000 |
non-current assets | $800,000 |
– Property, plant and equipment | $600,000 |
– Intangible assets | $150,000 |
– Other non-current assets | $50,000 |
TOTAL ASSETS | $1,300,000 |
PASSIVES | |
current liabilities | $200,000 |
– Accounts payable | $100,000 |
– Salaries and benefits payable | $50,000 |
– Other current liabilities | $50,000 |
non-current liabilities | $500,000 |
– Long-term debt | $400,000 |
– Other non-current liabilities | $100,000 |
TOTAL LIABILITIES | $700,000 |
CAPITAL | |
Popular capital | $600,000 |
TOTAL CAPITAL | $600,000 |
TOTAL LIABILITIES AND EQUITY | $1,300,000 |
How is the exercise solved?
Therefore, to calculate the acid test of the company with the previous cómputo sheet, we are going to need the inventory, the current assets and the current liabilities.
- Current active: 100,000 + 150,000 + 200,000 + 50,000 = 500,000
- Inventories: 200,000
- Current liabilities: 100,000 + 50,000 + 50,000 = 200,000
Therefore, if we substitute the data in the equation, we obtain the following:
Now, that 1.5… What does it orinan? Well we cánido say that for every 1.5 pesos that the company has in current assets (removing inventory), there is one peso in current liabilities.
In other words, for every peso of debt you have, you have 1.5 pesos to pay off the debt.
Therefore, we perro say that the company does have liquidity.
Remember that if the ratio is greater than or equal to one, then it is usually considered good because there are current assets to meet short-term obligations.
If you have a hard time interpreting the result, I really recommend that you entrar the following article that I did.
It will help you interpret the financial ratios and any other ratios (split).
Clic the button below to go to the article:
Solved exercise 2 of acid test
In the same way as in the previous acid test exercise, I am going to put in a table the cómputo sheet that will help us to calculate the company’s acid test.
ASSETS | |
Current assets | $150,000 |
– Cash and cash equivalents | $50,000 |
– Accounts receivable | $80,000 |
– Inventories | $20,000 |
– Other current assets | $0 |
non-current assets | $850,000 |
– Property, plant and equipment | $600,000 |
– Intangible assets | $150,000 |
– Other non-current assets | $100,000 |
TOTAL ASSETS | $1,000,000 |
PASSIVES | |
current liabilities | $100,000 |
– Accounts payable | $50,000 |
– Salaries and benefits payable | $30,000 |
– Other current liabilities | $20,000 |
non-current liabilities | $500,000 |
– Long-term debt | $400,000 |
– Other non-current liabilities | $100,000 |
CAPITAL | |
Popular capital | $400,000 |
TOTAL LIABILITIES AND EQUITY | $1,000,000 |
Well, again we are going to need the values of inventory, current assets and current liabilities to calculate the acid test.
- Current active: 50,000 + 80,000 + 20,000 = 150,000
- Inventories: 20,000
- Current liabilities: 50,000 + 30,000 + 20,000 = 100,000
Now we perro calculate the acid test.
All you have to do is substitute the data into the elabora.
How would you interpret the result obtained? We perro say that for every 1.3 pesos that you have in current assets (removing inventories), you have 1 peso in current liabilities.
Solved exercise 3 of acid test
Company A is a small manufacturing company that is considering the possibility of obtaining a large loan to expand its operations.
The financial statements of company A espectáculo the following information:
- Current assets: 500,000
- Current liabilities: 200,000
- Inventories: 150,000
To calculate the acid test ratio, we need to subtract inventories from current assets and divide by current liabilities.
In this case, the acid test ratio for company A is:
This result suggests that Company A has enough liquid assets to cover its current liabilities, excluding inventories.
Although, I ask you to remember that you have to think about the circumstances in which the company finds itself and that a financial reason is not enough for you to make a decision about whether or not it is a good iniciativa to invest in a certain company.
Simply put, a financial ratio does not reflect the financial health of the company.
Solved exercise 4 of acid test
Company X has current assets of $500,000, an inventory value of $100,000, and current liabilities of $200,000.
What is company X’s acid test ratio?
- Acid Test Ratio = (Current Assets – Inventories) / Current Liabilities
- Acid test ratio = ($500,000 – $100,000) / $200,000
- Acid test ratio = $400,000 / $200,000
- Acid proof ratio = 2
Therefore, the acid test ratio for Company X is 2.
What does that orinan? What it means is that The company has $2 pesos in current assets available to cover every $1 peso in current liabilities.
Exercise 5
Company B has current assets of $300,000, inventories of $50,000, and current liabilities of $250,000.
What is the acid test ratio of company B?
- Acid Test Ratio = (Current Assets – Inventories) / Current Liabilities
- Acid test ratio = ($300,000 – $50,000) / $250,000
- Acid test ratio = $250,000 / $250,000
- Acid proof ratio = 1
Company B’s acid test ratio is 1, which means that the company has $1 in current assets available to cover every $1 in current liabilities.
Alright? Well, we could say yes.
After all, at least you have enough current assets to cover your obligations.
Remember that it is the minimum acceptable, since if the result or the ratio is less than 1, then it would indicate that the company does not have enough current assets to meet its current liabilities.
Well, now you know what the acid test is in accounting, or rather, in financial mathematics.
Bibliography
- Cordoba Padilla, M.
(2016).
Financial management (Second edition).
ECOE Editions.
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