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Unlock This CourseThe acid test ratio is one of the most important tools for checking if a business can pay its bills quickly. It's called the "acid test" because it's a tough test - like putting gold in acid to see if it's real! This ratio tells us if a company can survive a financial crisis by only using its most liquid assets (cash and things that can quickly turn into cash).
Unlike the current ratio which includes all current assets, the acid test ratio is stricter. It only counts assets that can be turned into cash almost immediately, which makes it a more realistic measure of a company's short-term financial health.
Key Definitions:
The acid test ratio gives a clearer picture than the current ratio because it excludes stock (inventory). Stock can be hard to sell quickly, especially if it's outdated or damaged. By focusing only on liquid assets, this ratio shows if a business can handle immediate financial pressure without relying on selling stock.
The acid test ratio formula is straightforward, but you need to be careful about which assets to include. Here's the basic formula:
Acid Test Ratio = Liquid Assets ÷ Current Liabilities
Or written another way:
Acid Test Ratio = (Current Assets - Stock) ÷ Current Liabilities
When calculating the acid test ratio, you only include assets that can be turned into cash within a few days or weeks. Here's what typically counts:
Money in the till, current accounts and deposit accounts. This is the most liquid asset of all.
Money owed by customers who have bought goods on credit. Usually collected within 30-90 days.
Investments that can be sold quickly, like government bonds or shares in large companies.
Let's work through a practical example using a fictional company called "TechStart Ltd" to see how the acid test ratio calculation works in practice.
Current Assets:
Current Liabilities:
Step 1: Identify liquid assets (exclude stock and prepaid expenses)
Step 2: Calculate total current liabilities
Step 3: Apply the formula
Acid Test Ratio = £80,000 ÷ £80,000 = 1.0
Understanding what your acid test ratio means is crucial for making business decisions. The ratio tells a story about your company's financial health and ability to handle short-term pressures.
A ratio of 1.0 or above means the business can pay all its short-term debts using liquid assets. This suggests good financial health and the ability to handle unexpected expenses or economic downturns.
Ratios between 0.5 and 1.0 suggest potential cash flow problems. The business might struggle to pay bills if customers are slow to pay or if unexpected expenses arise.
Different industries have different "normal" acid test ratios. Here's what to expect:
Often have lower ratios (0.3-0.7) because they hold lots of stock and rely on quick turnover.
Usually have higher ratios (1.0-2.0) because they don't need to hold much stock.
Typically range from 0.7-1.2, depending on their production cycle and customer payment terms.
Background: A small chain of coffee shops with 5 locations
Liquid Assets: £45,000 (mostly cash and debtors from corporate catering)
Current Liabilities: £30,000 (suppliers and rent)
Acid Test Ratio: 1.5 (£45,000 ÷ £30,000)
Analysis: Excellent liquidity position. The business can easily pay its bills and has room for expansion or unexpected costs.
Background: Sports equipment retailer with seasonal sales patterns
Liquid Assets: £120,000 (cash, bank and customer payments due)
Current Liabilities: £200,000 (suppliers and short-term loans)
Acid Test Ratio: 0.6 (£120,000 ÷ £200,000)
Analysis: Concerning ratio suggesting potential cash flow problems. The business should focus on collecting debts faster or negotiating longer payment terms with suppliers.
Many students and even business owners make errors when calculating the acid test ratio. Here are the most common mistakes and how to avoid them:
Remember, stock is excluded from acid test calculations because it might be difficult to sell quickly. Only include cash, debtors and short-term investments that can be converted to cash within days or weeks.
Prepaid expenses (like insurance paid in advance) should be excluded because they can't be turned into cash. They're already spent money, just allocated to future periods.
Only include current liabilities (debts due within one year) in your calculation. Long-term loans and mortgages don't count because they don't need immediate payment.
If your business has a low acid test ratio, don't panic! There are several strategies you can use to improve it:
Chase overdue debts, offer early payment discounts to customers and delay non-essential purchases. These actions can quickly improve your liquid asset position.
Negotiate longer payment terms with suppliers, consider factoring (selling debts to a finance company), or arrange an overdraft facility for emergencies.