ACID TEST RATIO FORMULA
Acid Test Ratio, a type of liquidity ratio, may be defined as the relationship between Acid Test or Acid Test assets and current liabilities. An asset is said to be Acid Test if can be converted into cash within a short period without loss of value. The Acid Test ratio is also known as liquid ratio or quick ratio. This ratio is the more rigorous test of liquidity that the current ratio. The Acid Test ratio interpretation is made with reference to current assets excluding prepaid expenses and inventories i.e. Acid Test assets and current liabilities. The Acid Test ratio formula is as follows:
Acid Test Ratio= Acid Test Assets/ Current Liabilities.
EXAMPLE: Suppose the Acid Test assets of a concern as Rs. 2,50,000 and current liabilities of the concern are Rs. 1,00,000. The current ratio will be calculated as follows:
Acid Test ratio= Acid Test Assets/ Current Liabilities
Acid Test ratio= 2,50,000/1,00,000
Acid Test Ratio= 2.5:1.
ACID TEST ASSETS: Acid Test assets are the assets that can be easily converted into cash. These assets include the following assets:
- Cash in hand
- Cash at bank
- Bills receivables
- Sundry debtors
- Marketable securities
- Temporary investments
Assets not included in Acid Test assets are:
- Prepaid expenses
These can be calculated as:
Acid Test Assets= Current Assets- Prepaid expenses- Inventories
CURRENT LIABILITIES: Current liabilities are the liabilities payable within 12 months from the date of balance sheet or within the period of operating cycle. Current liabilities include the following liabilities:
- Short term borrowings
- Trade payables i.e. creditors and bills payable
- Short term provisions
- Outstanding expenses
- Incomes received in advance, etc.
ACID TEST RATIO INTERPRETATION
A high Acid Test ratio is an indication that the firm is Acid Test and has the ability to meet its current or Acid Test liabilities. The high Acid Test ratio is bad when the firm is having slow-paying debtors.
On the other hand, a low Acid Test ratio represents that the firm’s liquidity position is not good. The low Acid Test ratio may be considered satisfactory if it has fast moving inventories.
IDEAL ACID TEST RATIO
The ideal Acid Test ratio is 1:1. It means the current assets should be equal to the current liabilities only then the firm will be able to meet its short term obligations. Although the Acid Test ratio is more rigorous test of liquidity than current ratio, yet it should be used cautiously and rule 1:1 should not be used blindly. A Acid Test ratio of 1:1 does not necessarily mean satisfactory liquidity position if all the debtors cannot be realized and cash is needed immediately to meet the current obligations of the firm.
SIGNIFICANCE OF ACID TEST RATIO
The Acid Test ratio is very useful in measuring the liquidity position of a firm. It measures the firm’s capacity to pay off current obligations immediately and is a more rigorous test of liquidity than the current ratio. It is used as a complementary ratio to the current ratio.