The acid-test ratio (ATR) is one popular way to calculate a company’s liquidity, or the amount of cash or near-cash assets a company has to deal with immediate expenditures.
In comparing a company’s short-term assets against short-term liabilities, the acid-test ratio shows whether or not a company is well-financed. This ratio is subjective based on industry and the primary fundamentals of certain business models, but is a useful tool for gaining a basic understanding of a company’s liquidity level.
What Is the Acid Test Ratio?
An acid-test ratio (ATR), or quick ratio, is a comparison of a company’s most liquid short-term assets and short-term liabilities to calculate how much money it has to pay for immediate liabilities. In other words, it calculates how well a company can pay for short-term financial obligations with cash or assets that are easy to convert into cash.
The ATR disregards illiquid company financial assets such as real estate and inventory, instead focusing on the company’s ability to pay its current liabilities without needing to sell inventory or secure additional outside funding. This form of fundamental analysis is a more conservative measure than the current ratio, which includes all current assets when accounting for current liabilities.
A higher ATR indicates a company’s better liquidity and financial health, whereas a lower ratio indicates a company is more likely to struggle with paying immediate liabilities such as debts and other expenses. That being said, if a company takes longer to collect accounts receivable than usual or has current liabilities that are due but have no immediate payment needed, the acid-test ratio may not provide an accurate measurement of a company’s financial wellness.
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What Does the Acid-Test Ratio Tell You?
The acid-test ratio shows how financially capable a company is of paying short-term financial expenses. For beginner stock investors, calculating a company’s ATR may be an insightful fundamental analysis to look at a company’s financials.
An acid-test ratio of less than one indicates a company doesn’t hold sufficient liquid assets to cover current short-term liabilities and should be dealt with cautiously. It’s generally held that for most industries, the acid-test ratio should be greater than one.
However, a high ATR is not always best, as it could indicate an excess of idle cash that could otherwise be reinvested, returned to shareholders, or otherwise used productively for the business. For example, some technology companies generate substantial cash flows, which results in above-average acid-test ratios. While this indicates a healthy and productive business, some may advocate that shareholders who invest in the company should receive dividends from the company’s profits.
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If a company’s ATR is significantly lower than the current ratio, this indicates the company’s current assets largely depend on inventory. This isn’t necessarily a negative sign as some business models are inherently inventory-driven, such as retail stores, which typically have low acid-test ratios but aren’t necessarily in poor financial condition.
In such scenarios, it may make sense to consider other metrics such as inventory turnover. While acid-test ratios can vary widely based on industry, comparisons based on acid-test ratios can be more helpful when analyzing peer companies in the same industry.
How to Calculate the Acid-Test Ratio
The acid-test ratio is calculated as follows:
ATR = (Cash + Cash equivalents + Marketable securities + Current accounts receivables) ÷ Total current liabilities
To fully understand the ATR, it’s important to know the significance of each part of the equation:
• Cash and Cash Equivalents: The most liquid current assets on a company’s balance sheets:
◦ Savings accounts
◦ CD with maturity of less than three months
◦ Treasury bills
• Marketable Securities: Liquid financial instruments readily convertible into cash.
• Accounts Receivables: Money owed to the company from providing goods and/or services to customers/clients.
• Current Liabilities: Debts or obligations due within 12 months.
What Does the Numerator Mean in ATR?
The acid-test ratio’s numerator is ultimately a realistic assessment of the company’s liquid assets. This includes cash, cash equivalents, and short-term investments such as marketable securities, treasury bills, and very short-term deposits.
Accounts receivable are generally factored in as well, though there are industry-specific exceptions, such as construction, where accounts receivable may take significantly more time to recover than other industries — which may give the illusion the company’s financial condition is worse than in actuality.
Alternatively, the numerator can be calculated by subtracting illiquid assets, including inventory, from all current assets. This may negatively skew retail businesses’ financial condition because of the amount of inventory they typically hold. Additionally, subtract any other items that appear as assets on a balance sheet if they cannot be used to cover immediate-term liabilities such as prepayments, advances to supplies, and tax-deferred assets.
What Does the Denominator Mean in ATR?
The acid-test ratio’s denominator is composed of all current liabilities, defined as debts and financial obligations, due within 12 months.
Though time is not factored into the acid-test ratio formula, it can be a relevant variable. For example, if a company’s accounts payable are due sooner than its receivables are expected, the ratio may not factor for this time discrepancy that may arise, thus worsening the company’s financial health.
On the other hand, time can also be a benefit if accounts receivable are more frequent and regular than accounts payable, providing more frequent cash infusions to a possible undersupply of short-term assets.
Pros and Cons of the Acid-Test Ratio
When it comes to assessing the usefulness and accuracy of the ATR, there are both pros and cons.
Pros
1. It removes inventory from calculation, providing a more accurate picture of the company’s liquidity position.
2. It removes Bank Overdraft and Cash Credit from current liabilities because they are usually secured by inventory, thus making the ratio more tangible.
3. It’s not handicapped, as there is no need for valuation of inventory.
Cons
1. The ATR is not the sole determinant of a company’s liquidity. It’s commonly paired with other liquidity formulas such as current ratio or cash flow ratio to form a more complete and accurate assessment of a company’s financial condition and liquidity status.
2. ATR disregards inventory in calculating the ratio because inventory isn’t generally considered a liquid asset. However, for businesses that are able to quickly sell their inventory at market price, inventory would qualify as a near-cash asset.
3. It doesn’t provide information regarding time frame and degree of cash flows—fundamental factors in accurately calculating a company’s ability to satisfy its accounts payable when due.
4. It assumes accounts receivable are readily available, which may not be as easy as anticipated.
The Takeaway
The Acid-test ratio is an insightful and relatively accurate analysis of a company’s liquidity status. It’s one of the many methods for analyzing businesses, reviewing business fundamentals and company financials.
By comparing the company’s cash on-hand, near-cash equivalents, and easily convertible short-term assets against its current liabilities, one can surmise how readily prepared a company is to satisfy short-term liabilities. The formula determines how liquid a company is based on a variety of assets and expected cash flows versus expected accounts payable. This ratio, though not designed to be used solely, ultimately determines if a company is well capitalized or under financial strain. For an investor, this can help shine a light on whether or not a company may or may not be a promising investment.
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