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Acid Test Ratio
The Acid-Test ratio measures the short term liquidity of a company. During an Acid-Test analysis the short term assets are weighted against the current liabilities.
The name comes from the process of extracting gold from rock that are mined in gold mines. Gold, unlike other metals, do not corrode if submerged in acid. When the gold nugget is submerged in the acid an if it does not dissolve, that that really is gold. The concept regarding financial statements of companies indicate that is the company “passes” the Acid-Test Ratio, then the company, is able to pay its shot term debts.
To calculate it you need to divide the sum of the cash of the company, account receivables, and all the short term investments of the observed company with the current liabilities. It is very important, that when the numerator and the denominator of the ratio is assembled together only short term entries be considered; short term accounting entries that are liquid, that is, they can be monetized quickly and cheaply.
Lets see an example:
Say Company X has $1 million on its bank account, and in petty cash. Accounts receivables (these are short term credits owed to Company X) are $10 million. Short term investments (such as fixed term deposits) are $4 million. Current liabilities are (these are short term credits owed by Company X, such as to its suppliers of, say raw materials) $12 million. So the Acid-Test ratio of Company X is (1 mill+10 mill+4mill)/(12mill)=1.25.
Those companies that have an Acid-Test ratio lower than 1 usually have difficulties in paying their short term credits. To be able to, they would have to sell some of their asset. The problem with this is that if the company has very few assets, beside production facilities, office spaces, etc, the company might not have other option is to sell them.
Advantages of using the Acid-Test Ratio
The Acid-Test ratio can be used for virtually all companies, of which we know the key components. Often banks and financial institutions are in many ways different than other standard companies, however the Acid test ratio can be applied to them also.
The end result of the ratio is very easy to understand and conclusions based on the result can quickly be drawn. The primary issue that needs be considered is that the ratio has an end result of a minimum of 1, anything above that only reduces the risk of the company to run into liquidity or solvency problems.
The Acid-Test ratio measures purely the company’s financial performance. As outside factors only have a minor effect on the result the company, its conclusions are safe. As such it is also easy to compare it with that of other companies in the same industry.
Problems with the Acid-Test ratio
One of the problems of the Acid-Test ratio is the fact that account receivables and account liabilities play a vital role in the formula. In case of disputes between the company and one of its suppliers providing the company short term credit, the supplier may demand payments sooner than than the dates specified in the contract. The problem with this is that if the company’s supplier has a monopoly or virtual monopoly. Virtual monopoly is when there is the possibility to switch to other suppliers, but due to technical reasons, it might be very difficult or expensive characterized by the specific industry. In this case the liquidity problems, because the payment terms of current receivables remain constant.
Another problem is that the Acid-Test ratio is too much of a theoretical valuation method, its practicability is highly questionable. This ratio does not affect or measure neither the short term nor the long term performance or the value of the company. As liquidity problems occur only in special occasions, the ratio looses much of its usefulness.
Another problem poses from financial statements can be manipulated. In case of different accounting standards, the ratio may lead to wrong components input into the ratio’s formula, potentially resulting in misleading result.