Acid-test ratio

Definition

The acid-test ratio, also known as the quick ratio, measures a company's ability to pay off its current liabilities without relying on the sale of inventory. It is calculated by dividing quick assets (cash, marketable securities, and receivables) by current liabilities.

5 Must Know Facts For Your Next Test

1. The acid-test ratio excludes inventory from current assets because inventory may not be quickly convertible to cash.
2. A ratio of 1 or higher typically indicates that a company has sufficient liquidity to cover its short-term liabilities.
3. Quick assets include cash, marketable securities, and accounts receivable but exclude inventories and prepaid expenses.
4. The acid-test ratio provides a more stringent assessment of liquidity compared to the current ratio.
5. Industries with fast inventory turnover might have low acid-test ratios yet still maintain strong liquidity.

Review Questions

• What components are included in quick assets for calculating the acid-test ratio?
• Why is inventory excluded when calculating the acid-test ratio?
• What does an acid-test ratio of less than 1 indicate about a company's financial health?

Related terms

Current Ratio:

A liquidity ratio that measures a company's ability to cover its short-term obligations with its current assets.

Working Capital:

The difference between a company's current assets and current liabilities.

Liquidity:

The ability of a company to meet its short-term financial obligations.