The acid test ratio or quick ratio evaluates a company's short-term liquidity and is calculated by dividing cash plus cash equivalents by current liabilities. A ratio of one to one means the company could pay its invoices and short-term debt with its cash or assets it can turn to cash quickly.
The term "acid test" comes from the 18th century when the fact that nitric acid dissolved other metals but not gold was used to validate gold samples. Companies with a ratio larger than one to one are considered stable, although what is considered a good ratio varies by industry. A company with a ratio substantially less than one to one is having difficulty meeting its financial obligations and may have to sell assets to stay solvent.
TL;DR (Too Long; Didn't Read)
Calculate the acid test ratio by adding a company's cash and cash-equivalent assets together and dividing by the amount of current liabilities. A ratio greater than one to one means a company is solvent and can meet its short-term financial obligations. A ratio less than one to one means the company may be in financial difficulty and is having trouble paying its bills. It may have to sell some assets or delay paying its suppliers to stay solvent.
Calculating Acid Test Ratios
To calculate the acid test ratio, the assets that can easily be liquidated are added to the company's cash balance. Depending on the industry and the company's financial record, such assets could include accounts receivable and liquid investments. In the broadest definition, the key standard is that the assets must be available as cash within, at the latest, 90 days, but many calculations require liquidity over a shorter time frame.
For the denominator of the ratio, the current liabilities have to be added together. These always include accounts payable, but there may also be short term loans, dividends or lines of credit. The idea is to find out what has to be paid in the short term and compare it to the quick assets available.
Sometimes companies have access to a bank overdraft that would improve solvency. To take such cases into account, the adjusted acid test ratio subtracts the overdraft from the liabilities, because some of them can be paid using the overdraft instead of using quick assets. The effect of the adjustment is to raise the acid test ratio to a more favorable level.
How the Acid Test Ratio is Used
Loan officers and investors use the acid test ratio or quick ratio as a short cut to determine a company's viability and solvency. They add together amounts from the company's financial statements to see whether it is safe to lend the company money or invest in it. If the acid test ratio is less than one, often no further analysis is necessary and no loan or investment will be made.
If a loan is made, it often has conditions about company finances using the acid test ratio. For example, there may be a clause saying the acid test ratio will remain above 1.25 for the duration of the loan. Perhaps it will specify that the ratio has to be calculated every 60 days. If the ratio falls below 1.25, the bank can call in the loan, asking for repayment before the situation deteriorates further.
Suppliers will also often use the acid test ratio to determine if it is safe to extend credit or if they will insist on payment upon delivery. Normally, if a company is solvent, it should have an acid test ratio above one to one and suppliers can deliver goods, issue an invoice and ask for payment within 30 days. An acid test ratio below one to one means the company may not be there in 30 days or, if it is, it will have no money to make a payment. The acid test ratio is a key tool for quickly evaluating a company's financial viability.