Understanding the acid-test ratio

The acid-test ratio, commonly known as the quick ratio, uses a firm’s balance sheet data as an indicator of whether it has sufficient short-term assets to cover its short-term liabilities.

In certain situations, analysts prefer to use the acid-test ratio rather than the current ratio (also known as the working capital ratio) because the acid-test method ignores assets such as inventory, which may be difficult to quickly liquidate. The acid test ratio is thus a more conservative metric.

Companies with an acid-test ratio of less than 1 do not have enough liquid assets to pay their current liabilities and should be treated with caution. If the acid-test ratio is much lower than the current ratio, it means that a company’s current assets are highly dependent on inventory. This is not a bad sign in all cases, however, as some business models are inherently dependent on inventory. Retail stores, for example, may have very low acid-test ratios without necessarily being in danger. The acceptable range for an acid-test ratio will vary among different industries, and you’ll find that comparisons are most meaningful when analyzing peer companies in the same industry as each other.

For most industries, the acid-test ratio should exceed 1. On the other hand, a very high ratio is not always good. It could indicate that cash has accumulated and is idle, rather than being reinvested, returned to shareholders, or otherwise put to productive use.

Some tech companies generate massive cash flows and accordingly have acid-test ratios as high as 7 or 8. While this is certainly better than the alternative, these companies have drawn criticism from activist investors who would prefer that shareholders receive a portion of the profits. The numerator of the acid-test ratio can be defined in various ways, but the main consideration should be gaining a realistic view of the company’s liquid assets. Cash and cash equivalents should definitely be included, as should short-term investments, such as marketable securities.

Accounts receivable are generally included, but this is not appropriate for every industry. In the construction industry, for example, accounts receivable may take much more time to recover than is standard practice in other industries, so including it could make a firm’s financial position seem much more secure than it is in reality.

Both the current ratio, also known as the working capital ratio, and the acid-test ratio measure a company’s short-term ability to generate enough cash to pay off all debts should they become due at once.

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