Principles of Accounting: 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.