If a company's accounts payable are nearly due but its receivables won't come in for months, it could be on much shakier ground than its ratio would indicate. It is important to note that time is not factored into the acid-test ratio. The ratio's denominator should include all current liabilities, debts, and obligations due within one year. Other elements that appear as assets on a balance sheet should be subtracted if they cannot be used to cover liabilities in the short term, such as advances to suppliers, prepayments, and deferred tax assets. Most importantly, inventory should be subtracted, keeping in mind that this will negatively skew the picture for retail businesses because of the amount of inventory they carry. Acid Test = Current Liabilities Cash + Marketable Securities + A/R where: A/R = Accounts receivable Īnother way to calculate the numerator is to take all current assets and subtract illiquid assets. In the construction industry, for example, accounts receivable may take much more time to recover than is standard practice in other industries, so including it could make a firm's financial position seem much more secure than it is in reality. Cash and cash equivalents should definitely be included, as should short-term investments, such as marketable securities.Īccounts receivable are generally included, but this is not appropriate for every industry. This metric is more robust than the current ratio. ![]() The numerator of the acid-test ratio can be defined in various ways, but the primary consideration should be gaining a realistic view of the company's liquid assets. Acid-Test Ratio: The acid-test ratio is a strong indicator of whether a firm has sufficient short-term assets to cover its immediate liabilities. While this is certainly better than the alternative, these companies have drawn criticism from activist investors who would prefer that shareholders receive a portion of the profits. Some tech companies generate massive cash flows and accordingly have acid-test ratios as high as 7 or 8.
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