The acid test ratio is a quick indicator of the financial position of a firm. This ratio shows weather a firm has adequate amount of short term assets required to fulfill its short term liabilities without selling its inventory to fulfill short term liabilities. The acid test ratio is more intrinsic and laborious to calculate as compared capital ratio as in capital ratio the inventory is also included to fulfill short term liability of the firm. The formula of calculating the acid test ratio can be shown as under:-
Acid Test Ratio = Total Cash + Account Receivable + Short Term Investment / Current Liabilities of a Business
The values of acid test ratio can be 1, less than 1 and more than 1. Less than 1 value of acid test ratio shows that the company doesn’t have assets or cash in hand to fulfill its short term liabilities. Whereas the ratio greater than 1 indicates that company has enough amount of assets in the form of cash, accounts receivable or investment that will help to pay off its short term liabilities with ease. Acid test ratio can be compared with capital ratio and if acid test ratio is less that capital ratio it indicates that a company has to liquidate its inventory to fulfill its current short term liabilities.
Another simpler formula to depict acid test ratio is shown as under:-
Acid Test Ratio = Current Assets – Current Inventory/ Current Short Term Liabilities
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