Cambridge IGCSE Accounting(0452)/O Level Principles of Accounts(7110) Notes: Introduction to Liquidity Ratios: Acid Test Ratio / Quick Asset Ratio
- As pointed out in our discussion of the Current Asset Ratio
- Including stock when calculating stock might not be desirable
- This is because it might not always be easy to turn the asset of stock/inventory into liquid cash so as to be able to pay creditors
- In these instances the quick acid test ratio might be more appropriate
- It is a more stringent/rigorous ratio
- It is based on the realization that it might not be so easy to convert the item of stock into cash when creditors come knocking and the business has to pay
- In such cases a business might even have to sell its stocks on discount in order to quickly raise cash
- Including stock in determining liquidity can result in an inaccurate impression
- The ratio recognizes this fact by deducting the asset of stock from current assets
- The formula for the acid test ratio is:
- \mathrm{Acid \quad Test \quad Ratio = \dfrac{Current\quad Assets-Stock}{Current\quad Liabilities}}
- For example if the above mentioned business has stock valued at $ 1 500
- Then the acid test ratio would be:
- \mathrm{\dfrac{3000-1500}{1500}}
- 1
- As a general rule a ratio of 1 is considered ideal
- A lower ratio would mean that the business might be unable to meet its short term obligations
- A higher ratio means money is tied up in the form of current assets which are unprofitable
To access more topics go to the Principles of Accounting Notes.