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Acid-Test Ratio vs Current Ratio

Understand the Acid Test Ratio and Differences to the Current Ratio

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Acid-Test Ratio vs Current Ratio

Key Learning Objectives
  • What does the acid-test ratio measure?
  • How is the acid-test ratio different from the current ratio?
  • Which is more conservative: the acid-test ratio or the current ratio?
  • Which types of companies tend to have lower (and higher) acid-test ratios?

Acid Test Ratio Definition

Liquidity is among one of the most important aspects of a company and its long-term viability.

The acid-test ratio and current ratio are two frequently used metrics to measure near-term liquidity risk, or a company’s ability to quickly pay off liabilities coming due in the next twelve months.

The formulas for both are similar, although the noteworthy difference is that illiquid current assets — e.g. inventory — are excluded in the acid-test ratio.

Acid Test vs Current Ratio Formula

As one would reasonably expect, the value of the acid-test ratio will be a lower figure since fewer assets are included in the numerator.

Hence, the acid-test ratio is more conservative in terms of what is classified as a current asset in the formula.

The acid-test ratio compares the near-term assets of a company to its short-term liabilities to assess if the company in question has sufficient cash to pay off its short-term liabilities.

Liquid Current Assets in Acid-Test Ratio:

Current Assets in Current Ratio:

  • Cash & Equivalents
  • Marketable Securities
  • Accounts Receivable (A/R)
  • Inventory
  • Other Current Assets

If a company were to suddenly be required to pay off the entirety of its short-term liabilities, inventory is usually more time-consuming to liquidate (i.e. to sell and turn into cash) compared to marketable securities — which is where the acid-test ratio comes in.

Acid-Test Ratio vs Current Ratio Calculation Example

For example, let’s say a company has the following balance sheet data:

Current Assets

  • Cash = $20 million
  • Marketable Securities = $15 million
  • Accounts Receivable (A/R) = $25 million
  • Inventory = $60 million

Here, the total current assets are $120 million and the liquid current assets is $60 million.

Current Liabilities

  • Accounts Payables = $30 million
  • Short-Term Debt = $25 million

Then, the required inputs are entered into the two formulas:

  • Acid-Test Ratio = ($20 million + $15 million + $25 million) ÷ ($30 million + $10 million) = 1.5x
  • Current Ratio = ($20 million + $15 million + $25 million + $60 million) ÷ ($30 million + $10 million) = 3.0x

The current ratio in our example calculation is 3.0x while the acid-test ratio is 1.5x, which is attributable to the inclusion (or exclusion) of inventory in the respective calculations.

Interpreting the Acid-Test Ratio and Current Ratio

For both the acid-test ratio and current ratio, the same two general rules apply:

  • Higher Ratios → Increased Coverage of Current Liabilities
  • Lower Ratios → Decreased Coverage of Current Liabilities

Either liquidity ratio indicates whether a company — post-liquidation of its current assets — is going to have sufficient cash to pay off its near-term liabilities.

Therefore, the higher the ratio, the better the short-term liquidity health of the company.

The “floor” for both the quick ratio and current ratio is 1.0x, but this is the bare minimum, and higher values should be targeted.

In particular, a current ratio below 1.0x would be more concerning than a quick ratio below 1.0x, although either ratio being low could be a sign that liquidity might soon become a concern.

Ahe company with a low current or quick ratio should likely proceed with some degree of caution, and the next step would be to determine how much more capital and how quickly it could be obtained.

Acid-Test Ratio vs Current Ratio Excel Template

Now that we’ve defined and compared the acid-test ratio and current ratio, we can move on to a modeling exercise in Excel. For access to the model template, fill out the form below:

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Acid-Test Ratio vs Current Ratio Example Calculation

The model assumptions we’ll be using for our hypothetical company can be found below.

Balance Sheet Assumptions

Current Assets

  • Cash & Equivalents: $20m — Increases by $5m / Year
  • Marketable Securities: $15m — Increases by $2m / Year
  • Accounts Receivable (A/R): $25m — Increases by $2m / Year
  • Inventory: $80m — Increases by $40m / Year

Current Liabilities

  • Accounts Payable: $65m — Increases by $5m / Year
  • Short-Term Debt: $85m — Increases by $10m / Year

In Year 1, the current ratio can be calculated by dividing the sum of the liquid assets by the current liabilities.

  • Current Ratio — Year 1: ($20m Cash + $15m Marketable Securities + $25m A/R + $80m Inventory) ÷ $145m (Current Liabilities) = 1.0x

Current Ratio Calculation

Next, we apply the acid-test ratio formula in the same time period, which excludes inventory, as mentioned earlier.

  • Quick Ratio — Year 1: ($20m Cash + $15m Marketable Securities + $25m A/R) ÷ $145m (Current Liabilities) = 0.4x

Acid-Test Ratio Excel Formula

From Year 1 to Year 4, the following changes occur across the forecast period:

  • Current Ratio: 1.0x → 1.5x
  • Acid-Test Ratio: 0.4x → 0.5x

The current ratio is benefiting from the growth in the inventory balance, which is beneficial for debt lenders requiring capital (i.e. collateral), but the accumulation of inventory usually results from lower revenue due to lower market demand.

Since the target range for the current ratio is between 1.5x to 3.0x, the company appears to be in relatively good health based on its current ratio.

However, the acid-test ratio implies a different story regarding the liquidity of the company, as it is below 1.0x.

In closing, we can see the potentially significant differences that may arise between the two liquidity ratios due to the inclusion or exclusion of inventory in the calculation of current assets.

Acid Test vs Current Ratio Output

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