Acid-Test Ratio: Definition & Examples

Understanding a company’s financial health can be challenging. With so much information out there to consider, it can be hard to even know where to begin. That’s why investors often rely on simple rules of thumb that help them get a rough sense of the health of a company, before diving in deeper. The acid-test ratio is a good example of this. In this article, we will examine this helpful metric and explain how it can be an easy way to quickly gauge a company’s health. At the same time, we will also consider the limitations of this metric, and discuss why it needs to be interpreted carefully.

What is the Acid-Test Ratio?

The acid-test ratio, also known as the Quick Ratio, is a formula that investors use to quickly tell how easily a company can meet its short-term obligations (also known as “current liabilities”). It is calculated as follows:

Acid-Test Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

Sometimes, people will simplify this formula by calculating it as follows:

Acid-Test Ratio = (Current Assets - Inventories) / Current Liabilities

What is a good acid-test ratio?

A ratio above 1.0 means that the company can theoretically pay off all its current liabilities even without needing to sell off its inventory. I say “theoretically” because, in practice, the acid-test ratio doesn’t consider the exact timing that the payments are owed, so it will always be just a high-level approximation. Generally speaking, anything above 1.0 is considered a “good” ratio, while anything below 1.0 would start to raise concerns. 

That being said, it’s only possible to interpret the ratio by considering the trend for that company, how it compares to other companies in its industry, and the broader business context for the company.

Before we move further, let’s take a moment to break down what each component of the formula means.

Acid Test Ratio Formula Components

Acid-Test Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

As you can see, the formula is essentially “weighing” two parts of a company’s financials. On one side, you have assets that are all short-term in nature, meaning that they can be converted into cash within one year. On the other side, you have the current liabilities, which are liabilities that must be paid within one year. Generally speaking, a higher ratio is better, since it means the company has a larger cushion with which to pay its bills.

Cash and Equivalents

Cash and Equivalents refers to cash and other assets that can be converted into cash very quickly, with little to no risk of the asset losing value in the process. For example: 

• Money held in checking accounts
• Money-market funds
• Physical bills

Marketable Securities

Marketable Securities are similar to Cash and Equivalents, except they are not quite as liquid. For instance, shares of publicly traded stock that could be sold quickly and converted to cash would be considered marketable securities. The same would be true for bonds, as long as the bonds are liquid and could be sold quickly. Essentially, Marketable Securities are just securities that could be quickly “brought to market” and sold.

Accounts Receivable

Accounts Receivable (often referred to simply as “AR”) is the money owed to the company by its customers. Often, this is accumulated by customers being allowed to pay the company on credit, such as with the common “net 30” payment terms. In that example, the customer can take up to 30 days to pay, although in some industries (such as construction) common payment terms can be much longer. In almost all cases, Accounts Receivable is expected to be paid within one year, which is why it is considered a short-term asset for our purposes. 

So adding all these together gives us three assets that are all highly liquid, and hence a reliable source of cash for paying our bills. The denominator, on the other hand, Current Liabilities, are the bills that the company needs to pay within one year. Depending on the company, this could be composed of various liabilities. Two common examples are:

• Accounts Payable (essentially the opposite of accounts payable: that is, money owed by the company to its suppliers).
• Accrued Liabilities (such as taxes and wage-related costs that have been incurred but not yet paid).

Why is inventory not included in the Acid-Test Ratio?

You may be wondering why inventory isn’t included in the Acid-Test Ratio. After all, isn’t inventory also an asset that is typically converted into cash within one year? This is a good observation, and indeed it is true that from a businessperson’s perspective, it’s certainly possible (and quite common) to generate short-term cash by selling off inventory. However, inventory is deliberately excluded from the acid-test ratio in an effort to make the ratio even more conservative. 

The reason for this is that inventories are not always easy to convert into cash. Sometimes, inventory becomes less valuable due to factors such as changes in consumer trends (think of a fashion retailer, for example), technological obsolescence (old-model smartphones or cameras, for instance) or even outright physical degradation (such as food products that are past their ‘best-before’ date).

Acid-Test Ratio Example

Let’s imagine we run a small furniture retailer. We hold substantial inventory, but we know that with consumer trends always changing, it is not always easy to quickly sell off our inventory—at least, not without providing steep discounts. For that reason, we want to calculate our Acid Test Ratio to make sure we have the resources to meet our bills even without counting on our inventory.

Reviewing our accounts, we find that we have $100,000 in the bank, plus an additional $50,000 invested in deposit accounts and other short-term, highly liquid investments. Our customers owe us $150,000 in AR, and we have Current Liabilities of $250,000. 

In this scenario, our Acid Test Ratio would be:

Acid Test Ratio = ($100,000 in cash + $50,000 in marketable securities + $150,000 in AR) / $250,000 in Current Liabilities = 1.20

It is not uncommon for certain industries to have ratios below 1, especially industries that hold a lot of inventory, such as retailers. Therefore, in this scenario, we would probably conclude that we are relatively healthy. If we wanted to further improve our ratio, however, we could take measures such as collecting our AR more proactively, or taking longer to pay our suppliers.

Acid-Test Ratio Real-World Example

Now that we are familiar with the concept of acid-test ratio, let’s calculate it using real numbers from a large publicly traded company: Apple Inc. (AAPL). For this example, we will use the simplified version of the Acid-Test Ratio:

Acid-Test Ratio = (Current Assets - Inventory) / Current Liabilities

In its quarter ended March 31st, 2023, Apple Inc. (AAPL) had Current Assets of $112.91 billion, of which $7.48 billion consisted of inventory. Its Current Liabilities were $120.08 billion. Therefore, its Acid Test Ratio was:

Acid Test Ratio = ($112.91 billion in Current Assets - $7.48 billion in inventory) / $120.08 billion in Current Liabilities = 0.88

This result may come as a bit of a surprise, since Apple is known for being one of the financially strongest companies in the world. Let’s reflect on this some more in the following section.

Interpreting the Acid-Test Ratio

So, suppose you’ve calculated the Acid-Test Ratio of a company, and it seems low. Now what? Really, this ratio may not tell you very much in isolation. A good next step would be to ask further questions, such as whether it has been trending upward or downward over time, and how the ratio compares to other companies in its industry. It’s only by asking follow-up questions and placing the Acid-Test Ratio alongside other relevant data that you can start to piece together a meaningful picture of the company’s financial health. And in doing that further research, you may also want to move beyond the numbers and consider the broader business context, such as by reading the Management Discussion and Analysis (MD&A) section of the company’s annual 10-K filing, or by reading the transcripts from its recent earnings calls.

For example, in the case of Apple, further research would reveal that the Acid-Test Ratio has declined in recent years, partly because the company decided to pay out part of its cash to shareholders in the form of a dividend. In the end, the Acid-Test Ratio should be viewed as a single piece of a large puzzle, rather than as a one-stop gauge of a company’s financial health.

Acid-Test Ratio vs Current Ratio

If you want to see a different ratio that does include inventory, you can take a look at the Current Ratio. The Current Ratio is essentially a slightly less conservative version of the Acid-Test Ratio, one which does include inventory on the assets side of the scale. Depending on how you look at it, this can either be an advantage or a disadvantage. It’s an advantage because it means the ratio won’t be inflated by inventory which might end up being worth less than its stated value. On the other hand, it’s a disadvantage in that it can make some companies (such as profitable retailers) seem less financially healthy than they really are.

Additional Resources

If you found this article useful, consider checking out our Complete Finance & Valuation Course where you can master the fundamentals of finance, valuation, and financial modeling. Students who have completed this course have gone on to Goldman Sachs, Amazon, Bloomberg, and other high-profile companies.

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