Concepts Behind Acid Test Ratio
Acid Test Ratio which is commonly known as Quick Ratio is a liquidity ratio which measures the immediate ability of a business to pay off its short term liabilities. It takes into consideration only liquid assets which are equivalent to cash. For this purpose, prepaid expenses and inventory are not included when the Acid Test Ratio is calculated.
Also, any other assets which can take a period of more than 90 days to convert into assets are not qualified to be called liquid assets. It is calculated in order to know how capable a business is or how much assets it holds such that it can pay off its short term debts in a short term notice. Also, the assets which are not very liquid have a high chance of not being able to convert into cash readily. For instance, stock at times gets worn out. Even if it is included in Current assets, there is no way it can realize a saleable value. Thus, Acid Test ratio takes this into consideration and gives an accurate picture of the firm's liquidity position.
It is calculated as under:
ATR= Liquid Assets or Quick Assets/Current Liabilities
Liquid assets or quick assets include Cash, Bank Balance, Debtors and Short term investments.
Analysis Of The Acid Test Ratio:
The industry standard for this ratio is usually 1:1. If it goes below 1, it is a cause of concern for the business. It means that the business or organization does not have enough liquid assets to dispose off their current liabilities and may default in case their other current assets become obsolete like stock or inventory. 1:1 is considered a safe and good position for a business as it shows the company is balanced and has the ability to pay off its current liabilities immediately if the need arises. A ratio of higher than one is considered extremely well. It means that the company has enough liquid assets to pay off its current liabilities at any point of time. A very high Acid Test Ratio can also be a concern as it shows that the business has excess of cash which could have been used for better investment purposes.
The Acid Ratio derives its name from the historical phenomenon of testing for gold in ancient times. Acid used to pour to metals. If the metal passed the test, it would be identified as gold.
Similarly for companies, if they pass the Acid Test of being 1:1 or higher, it is considered as a credible company.
Acid Test Ratio is mostly preferred over the Current ratio as it gives a clearer picture of firm's ability to pay its short term credit. A high Acid Test ratio makes the company seem credible and suppliers can ensure their trust in the company and extend credit goods with confidence. Lenders and investors also get attracted to a company with a high Acid Test Ratio.
Difficulties Encountered In Acid Test Ratio
Like mentioned above, a company might try to manipulate and fabricate information in its transactions and financial statements in order to show a higher Cash Flow from Operations and lower current liabilities in order to present to the users a better position of the company by showing a better Acid Test Ratio.
Also, the balance sheet and profit and loss accounts are calculated on accrual basis. Thus, students are required to know Cash Flow Statements thoroughly in order to calculate this ratio. The students get confused in choosing the transactions which are to be taken into consideration for calculating the ratio. The calculation of the ratio is quite simple but the elements that go into it requires an in depth knowledge of the nature of the elements and keeping the find the principle of accrual and actual.
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