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.