Word of the Week: Acid Test Ratio
Liquidity! What is it? It is the ability of current assets to meet current liability when due. How does a business owner test they have enough liquidity? They will use what is called an acid test ratio. The ratio is found by dividing the most liquid current assets (cash, marketable securities, and account receivables) by current liabilities.
In general, the ratio should be equal to one or greater. In other words, for every $1.00 in current debt, there should be $1.00 in quick assets. Assume, as a business owner, that you have $500 in cash, $800 and marketable securities, $1,600 in accounts receivables, inventory is $9,000, and your current liabilities are $2,000.
The acid test ratio equals:
Quick Assets $2,900
------------------ = 1.45
Current Liabilities: $2,000
Wait! If you add $500 in cash, $800 in marketable securities, $1,600 in accounts receivables, and $9,000 in inventory you get $11,900. And you do, but inventory is not in the numerator because it usually takes a long time to convert into cash; prepaid expenses are left out because they cannot be turned into cash thus are incapable of covering current liabilities.
A strong liquid business will have more financial flexibility to take on new investment opportunities.
The acid test ratio for the current year should be compared to prior years to evaluate the trend.
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Disclaimer: This blog is for information purposes only and is not intended to provide investing, accounting, tax or legal advice and should not be relied upon.