Some tech companies generate massive cash flow and therefore have acid test ratios of up to 7 or 8. While it`s certainly better than the alternative, these companies have drawn criticism from activist investors who would prefer shareholders to receive a portion of the profits. A company`s acid/test ratio can be calculated based on its balance sheet. Below is an abridged version of Apple Inc.`s (AAPL) balance sheet as of January 27, 2022, showing the components of the company`s current assets and liabilities (all figures in millions of dollars): To calculate a company`s difficulty test ratio, add its cash, marketable securities and receivables, and then divide by the total amount of current liabilities. All this information is disclosed in separate items on a company`s balance sheet. Current liabilities are presented as a subtotal in the balance sheet. The formula for the acid-test ratio is as follows: Increasing your sales will improve your inventory turnover, which can increase a company`s cash balance. Increased sales and inventories mean the company has more cash to meet its short-term obligations. In order for stocks to be converted into cash, they must be actively sold. Increasing sales that return your inventory improves your acidity ratio test. According to the Merriam-Webster dictionary, the term acid test was coined in 1854 „from the use of nitric acid to determine the gold content of jewelry.” Merriam-Webster defines the endurance test as a „severe or decisive test”. The endurance test report equation can also be calculated as follows: This article defines the acid test report and explains why it is important. We propose a formula to calculate the acid test ratio.
In addition, we discuss some levers that finance management can use to improve their company`s acid/test ratio results for better financial health. The difficulty-to-hardship ratio is important because it measures a company`s liquidity and ability to pay its bills and other short-term obligations with short-term assets that can be quickly converted into cash. Companies that do not have liquidity problems can focus on their competitive strategies to increase their market share without losing control of the company in the event of insolvency or bankruptcy. Calculate Apple Inc.`s acid-test ratio for the period up to September 29, 2018: – A shorter period to collect your receivables will have a direct and positive effect on your company`s acidity test. An acid-test ratio, also known as a quick ratio, is a financial measure of a company`s ability to repay its current liabilities, that is, any debt that needs to be repaid within a year, such as credit card fees and accounts payable. The acid test indicates whether a company can repay these debts immediately with cash or current assets. It is a measure of a company`s short-term financial health. As your business better manages accounts payable and payments, it will have the opportunity to take advantage of the discounts offered by its suppliers for advance payments. Taking discounts reduces the cost of purchases, which means that cash balances are higher than if they had to pay the full amount of the bill. Higher cash flow means a higher acid-to-test ratio and more liquidity. If your business has capital assets such as excess equipment or inventory that is not being used, the business could get money by selling those assets to non-customer buyers.
Generating more money increases the acid-test ratio. Here are the calculations of the acid-test ratio for each company: The current ratio is a less conservative measure than the acid-test ratio because it includes inventory. If a company`s inventory liquidation takes a long time, the current ratio can be misleading, as it is assumed that inventories can be easily converted into cash. The acid-test ratio does not make such an assumption, as it excludes the stock from the calculation. The acid-test ratio compares a company`s most common assets to its current liabilities. The purpose of this relationship is to assess whether a company has sufficient liquidity to pay its immediate obligations. If this is not the case, there is a considerable risk of default. It is often used by creditors and lenders to evaluate their customers or borrowers. Investors can also use it to detect if a company has so much excess money that it can afford to issue them a dividend.
A low or decreasing acid test ratio usually indicates that a company is struggling to maintain or increase sales, pay bills too quickly, collect receivables too slowly, or be over-indebted. The endurance test, also known as the quick ratio test, is a liquidity ratio that measures a company`s ability to settle its current liabilities when they mature only with fast assets. A fast asset is one that can be converted into cash within 90 days. Cash, cash equivalents, short-term investments or marketable securities as well as current receivables are considered quick assets. The acid-test ratio, commonly referred to as the quick ratio, uses data from a company`s balance sheet as an indicator of whether it has enough current assets to cover its current liabilities. Checking customers` ability to pay invoices on time reduces the risk of bad debts. If the exemption limit for suspicious accounts is lower, the difficulty rate is higher. And trade receivables are converted into cash faster, increasing your company`s liquidity and financial flexibility. On the other hand, a high or increasing acid test ratio indicates that a company has faster inventory turnover and cash conversion cycles.
This measure occurs when a company experiences revenue growth, quickly converts its receivables into cash, and can easily meet its financial obligations. In some situations, analysts prefer to use the acid-test ratio instead of the current ratio (also known as the working capital ratio) because the acid test method ignores assets such as inventories that can be difficult to liquidate quickly. The endurance test report is therefore a more conservative measure. The higher the ratio, the better the liquidity of the company and the overall financial health. A ratio of 2 means that the company has $2 in cash and cash equivalents to cover $1 in current liabilities each. However, it is important to note that an extremely high quick ratio (for example, a ratio of 10) is not considered favorable, as this may indicate that the company has a cash surplus that is not being used wisely to grow its business. A very high rate may also indicate that the company`s debts are too high – and this may indicate collection problems. How to improve the acid-test ratio to achieve more liquidity requires an understanding of the different components of the ratio calculation and the overall cash conversion cycle. Acid testing rates, which are much lower than the current ratio, mean that working capital is highly dependent on inventory.
This isn`t always a bad sign, as some business models depend on inventory. Retail stores can have a very low acid test rate without necessarily being in financial danger. In these cases, other measures such as stock turnover must be taken into account. Retail companies typically have very low acid test ratios because they are heavily invested in inventory. This reliance on stocks increases their current liabilities, but does not necessarily mean they have financial problems. Some of the country`s largest big-box retailers typically have acid test ratios below 0.50 and are quite profitable. If a company`s asset testing rate is too low, lenders may be reluctant to offer financing to the business because the risk of insolvency is higher. Methods to improve sales and asset utilization or turnaround can increase the company`s current assets and improve a low acid/test ratio.
7 levers to improve the acid test ratio that measure a company`s liquidity are: The acid-test ratio is considered the strictest calculation of short-term liquidity. The calculation formula is as follows: The acid test ratio (or quick ratio) is a formula used to determine a company`s ability to pay its bills on time by comparing its most current assets to its most common liabilities and checking whether it has enough cash to pay these immediate liabilities. The hardship ratio does not include current assets that are difficult to liquidate, such as inventories, but current liabilities. The acid-test ratio is used to indicate a company`s ability to settle its current liabilities without relying on the sale of inventory or obtaining additional financing. Inventory is not included in the calculation of the ratio as it is usually not an asset that can be easily and quickly converted into cash. Compared to the current ratio – a liquidity or debt ratio that includes the inventory value in the calculation – the acid-test ratio is considered a more conservative assessment of a company`s financial health. A great advantage of using the acid-test ratio is that the information needed to create it is in a company`s balance sheet.