Acid Test Ratio

The Acid Test Ratio, also known as the Quick Ratio, is a financial metric used to assess a company’s short-term Liquidity position. It measures a company’s ability to pay off its Current Liabilities without relying on the sale of Inventory. The formula for calculating the Acid Test Ratio is:

Acid Test Ratio = (Current Assets – Inventory) / Current Liabilities

A ratio of 1 or higher indicates that a company has enough liquid Assets to cover its Current Liabilities, while a ratio below 1 may suggest potential Liquidity issues.

Example:

• Current Assets: $200,000
• Inventory: $50,000
• Current Liabilities: $100,000

Calculation:

Acid Test Ratio = ($200,000 – $50,000) / $100,000 = $150,000 / $100,000 = 1.5

This means the company has $1.50 in liquid Assets for every $1.00 of Current Liabilities.

Case:

Consider a tech startup that has minimal Inventory but substantial cash reserves. If the startup has:

• Current Assets: $500,000
• Inventory: $10,000
• Current Liabilities: $300,000

Calculation:

Acid Test Ratio = ($500,000 – $10,000) / $300,000 = $490,000 / $300,000 = 1.63

This indicates strong Liquidity, showing that the startup can easily cover its short-term obligations.