ACID TEST RATIO (QUICK RATIO/LIQUID CAPITAL RATIO)
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 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). The Acid Test ratio is different to the Current Ratio because stock is not included in the (value of the) current assets used in the calculation.
Why is Stock (inventory) Not Included In the Calculation
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 Inventory can “go out of date”, get damaged or lose value, so the acid test ratio shows you how many times the business can pay off its current liabilities, if stock is not included as a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.
How Do I Calculate the Acid Test Ratio For a Firm
Acid Test Ratio Current Assets - Stock
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
What Does the Answer (number 3) in the Example Mean?
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.
How Do I Write The Ratio?
As Liquidity ratios are expressed against 1 my acid test ratio for this example is 3:1.