Acid Test Ratio

The acid test ratio is another important and widely used liquidity ratio, particularly in industries where it is traditional to carry a large value of stocks (inventories) in working capital.

Not all assets can be turned into cash quickly or easily. Some - notably raw materials and other stocks - must first be turned into final product, then sold and the cash collected from debtors.

The Acid Test Ratio (sometimes also called the "Quick Ratio") therefore adjusts the Current Ratio to eliminate certain current assets that are not already in cash (or "near-cash") form. The tradition is to remove inventories from the current assets total, since inventories are assumed to be the most illiquid part of current assets – it is harder to turn them into cash quickly.

Some care has to be taken interpreting the acid test ratio. The value of inventories a business needs to hold will vary considerably from industry to industry.

For example, you wouldn't expect a firm of solicitors to carry much inventory, but a major supermarket needs to carrying huge quantities at any one time.

An acid test ratio for Tesco or Asda would indicate a very low figure after taking off the value of inventories but leaving in the very high amounts owed to suppliers (trade creditors). However, there is no suggestion that either of these two businesses has a problem being able to pay its debts!

The trick is to consider what a sensible figure is for the industry under review. A good discipline is to find an industry average and then compare the current and acid test ratios against for the business concerned against that average.