Definition: The acid test ratio, sometimes called the quick ratio, is a liquidity ratio that measures a company’s ability to pay off its current debts with only quick assets. Quick assets, sometimes called cash equivalents, are current assets that can be quickly and easily converted into cash in the current period. These assets include cash, short-term investments, and current receivables.
What Does Acid Test Mean?
What is the definition of acid test ratio? In a sense, the quick ratio is a quiz to see how liquid a company is by comparing the current liabilities with the quick assets. If a company has enough cash and cash equivalents to pay off its current debt, creditors shouldn’t be worried about being paid. The company can easily meet all of its current obligations without having to sell any of its long-term assets. Investors will also be happy because companies that maintain high levels of liquidity are typically stable and grow more profitable in the future.
The acid test ratio formula is calculated by dividing quick assets by current liabilities.
Let’s take a look at an example.
Sally’s Shoe Store is considering opening another location, but Sally needs to obtain bank financing in order to afford the new location. The bank asks to see her financial statements to evaluate her liquidity.
Sally’s balance sheet shows $1,000 of cash and $2,000 of accounts receivable. Sally doesn’t have marketable investments or securities. The balance sheet also reports current liabilities of $2,000 making her quick ratio equate to 1.5 ($1,000 + $2,000 / $2,000).
This means that Sally has even quick assets to cover current debt obligations 1.5 times over. In other words, Sally can pay off all of her current debt and still have cash in the bank. This is exactly what the bank wants to see. Sally will probably get her loan after the bank evaluates a few other financial ratios.
Define Acid Test: Quick ratio means a measurement of a company’s liquity by comparing current assets to the most liquid of current assets.