Not all assets can be turned into cash quickly or easily. Some - notably raw materials and other stocks - must first be turned into final product, then sold and the cash collected from debtors. The acid test ratio (sometimes also called the “quick ratio”) therefore adjusts the current ratio to remove the value of stocks from the current assets total. This is because stocks are assumed to be the most illiquid part of current assets – it is harder to turn them into cash quickly.
The formula for the acid test ratio is:
An example of the calculation is shown below:
An acid test ratio of over 1.0 is generally good news; the business should able to pay its debts even if it cannot turn stocks into cash.
Some care has to be taken interpreting the acid test ratio. The value of stocks a business needs to hold will vary considerably from industry to industry. For example, you wouldn’t expect a firm of solicitors to carry much stock, but a major supermarket needs to carrying huge quantities at any one time.
An acid test ratio for Tesco or Asda would indicate a very low figure after taking off the value of stocks but leaving in the very high amounts owed to suppliers (trade creditors). However, there is no suggestion that either of these two businesses has a problem being able to pay its debts!
The trick is to consider what a sensible figure is for the industry under review. A good discipline is to find an industry average and then compare the current and acid test ratios against for the business concerned against that average.