Quick Ratio & Acid Test: Complete Guide

Calculation Formula | Examples | What Is "Good" | Analysis & Interpretation | Definition & Meaning

Definition: WHAT Is Quick Ratio / Acid Test Ratio?

Quick ratio, or acid test ratio, calculates how well current liabilities are covered by liquid assets by excluding illiquid inventory from current assets to provide more accurate measure of short-term liquidity for entities with long inventory cash cycles.

Formula: HOW to Calculate Quick Ratio / Acid Test Ratio?

(Current Assets - Inventory) / Current Liabilities.

Quick ratio, or acid test ratio, is calculated by dividing current assets less inventory by current liabilities.

Meaning: WHEN to Use Quick Ratio / Acid Test?

The quick ratio / acid test ratio provides an indication of a company’s short-term liquidity position (= time taken to convert into cash) and reflects the fact that some businesses are not able to convert inventory into cash as fast as others.

For example, some manufacturing companies hold large quantities of raw materials for the production of finished goods, which are then warehoused and sold on credit for a lengthy period of time.

In such businesses with slow inventory turnover and long cash cycle, stock is not a very liquid asset, compared to cash and other receivables.

Consequently, it would distort the ratio if inventory was used to assess short-term liquidity.

Instead, we calculate the quick ratio, which is the ratio of current assets less inventories to current liabilities.

"Acid Test": WHY is the Quick Ratio also called Acid Test Ratio?

The quick ratio is also known as the acid test ratio because by eliminating inventory from current assets it provides the acid test of whether the company has sufficient liquid resources to settle its liabilities.

What Is a ‘Good’ Quick Ratio / Acid Test?

Quick ratio / acid test ratio should ideally be at least 1 for businesses with a slow inventory turnover. For companies with a fast inventory turnover, the ratio can be less than 1 without suggesting any liquidity issues.

A measure of 1:1 means that an entity is able to meet existing liabilities if they all fall due at once.

Some say that acceptable levels for the quick ratio range from 1:1 to 0.7:1.

But the absolute figures should only be used as a general guide.

Analysis: HOW Do You Interpret Quick Ratio / Acid Test?

In addition to analysing how ‘safe’ a business is based on the quick / acid test ratios alone, it is important to examine the figures in context, including the following considerations:

Benchmarks: Consider the nature of the business (e.g., supermarket have ratios as low as 0.10, compared to a manufacturer or retailer with 1.0)
Trends: Ratio trends will indicate whether liquidity is improving or deteriorating (e.g. year-on-year).
Source: Examine why the ratios have moved, for example, look for the following issues:
- Overdraft: Entity may have sufficient bank overdraft facilities available to help manage a low quick ratio.
- Cash: Quick ratio could be high if overtrading with receivables, but no cash.
- Debt: Cash inflows may have come from taking on more debt rather than entity’s performance.
- Working capital: Excessively large ratio may indicate overinvesting in working capital, tying up more funds in the business than needed, as a result of inefficient management of receivables or inventory.

When it comes to the analysis and interpretation of the quick / acid test ratio, the comments are largely the same as for the current ratio.

What's the Difference Between Quick Ratio VS. Current Ratio?

Both the quick ratio and the current ratio offer an indication of a company’s short-term liquidity position and so both are calculated with formulas that are identical with only one–but significant–difference: in acid test ratio, inventory is removed from the current assets.

Consequently, the quick / acid test ratio offers the following advantages compared to the current ratio:

Measures how well current liabilities are covered by liquid assets by excluding illiquid inventory
Becomes particularly useful where inventory holding periods and cash cycles are long
Eliminates often subjectively valued inventory from the calculation

However, for business with normal speed of inventory turnover, where we do not want to exclude inventory from the calculation, use the current ratio instead.

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