Acid Test Ratio Formula
Acid test ratio = (Total Current Assets – Inventory) / Total Current Liabilities
Advantages of Acid Test Ratio
- The acid test ratio removes the inventory from the calculation, which may not always be considered liquid, thereby giving a more appropriate picture of the company’s liquidity position.
- Since inventory is excluded from current assets; bank overdraft and cash credit are removed from current liabilities as they are usually secured by inventory thereby making the ratio more meaningful in arriving at the liquidity position of the company.
- Valuation of inventory can be tricky and it may not always be at marketable value. Thus, acid test ratio is not handicapped as there is no need for valuation of the inventory.
- Inventory can be very seasonal in nature and may vary in quantity over a yearly period. If considered, it may deflate or inflate liquidity position. By avoiding inventory from the calculation, acid test ratio does away with this problem.
- In a dying industry, which usually may have very high level of inventory; this ratio will provide more reliable repayment ability of the company as against the current ratio which includes inventory.
- Due to large inventory base, a company’s short-term financial strength may be overstated if current ratio is used. By using acid test ratio this situation can be handled and will limit companies getting an additional loan; the servicing of which may not be as easy as stated by current ratio.
Disadvantages of Acid Test Ratio
- Using this ratio on a standalone basis may not be sufficient to analyse the liquidity position of the company. A comparative analysis with the peers and industry standard may be required for effective analysis.
- This ratio removes inventory from the calculation, which may not be appropriate for businesses where inventory can be valued at a marketable price easily. It should rather be included than excluded to arrive at the liquidity position of the company.
- This ratio may not be a good indicator for all business models for showing short term solvency because if companies with usually higher inventory, like supermarkets exclude inventory to arrive at liquidity position, it may not be essentially correct to do so.
- The acid test ratio ignores the level and the timing of the cash flows which actually would be a major parameter determining the company’s ability to pay liabilities when they become due.
- The ratio considers accounts receivables as liquid and can be easily converted to cash which may not always be the case.