Learn: Acid Test Ratio - Calculation and Interpretation

Welcome!You've already learned about financial ratios like the Current Ratio and how to interpret balance sheets. Today, we'll build on that by exploring the Acid Test Ratio, an important tool for assessing a business's liquidity.

What is the Acid Test Ratio?The Acid Test Ratio is a financial measure that shows whether a business can pay its short-term liabilities without relying on selling its inventory. It’s a stricter test of liquidity compared to the Current Ratio.

Why is it important?Inventory can be hard to convert into cash quickly, so excluding it from the calculation gives a clearer picture of whether a business can meet its immediate obligations. This is especially useful for businesses with slow-moving stock.

Formula for Acid Test RatioThe formula is:Acid Test Ratio = (Current Assets - Inventory) / Current LiabilitiesThis calculation removes inventory from current assets to focus on liquid assets like cash and receivables.

How to interpret the Acid Test RatioAn Acid Test Ratio of 1:1 or higher generally indicates good liquidity, meaning the business can cover its short-term liabilities with liquid assets. A lower ratio may suggest potential liquidity issues.

Comparing Acid Test Ratio to Current RatioBoth ratios assess liquidity, but the Current Ratio includes inventory, whereas the Acid Test Ratio excludes it. This makes the Acid Test Ratio a more conservative measure of liquidity.

Review Time!Great work! You've learned about the Acid Test Ratio, its formula, and how to interpret it. Let’s test your understanding with a few final questions.

Lesson Complete!Well done! You've mastered the Acid Test Ratio, including its formula, interpretation, and importance. Keep practising to reinforce your understanding!