Acid-test ratio / Quick ratio / Liquidity metrics

The acid-test ratio (also called the quick ratio) is a financial statement metric designed as a measure of a company's liquidity, that is, the company's ability to meet current (short term) obligations. The acid-test ratio is similar to other metrics, the current ratio and working capital. All these metrics address the question: How well positioned is the company to pay its immediate bills? Among the three metrics mentioned, the acid-test is the most severe (most pessimistic).

Poor scores on these metrics may signal that the company is unable to invest in research and development that it needs in order to remain competitive. Or, poor liquidity can mean that the company will have to cut corners on infrastructure maintenance, or reduce advertising and promotion expenses (thereby cutting into future sales). In extreme cases, the company may not even be able to meet payroll.

Employees may feel the effects of liquidity problems through such measures as pay rate freezes, and restrictions on hiring, travel, and training. Good liquidity, on the other hand, means that management has the ability to pursue objectives other than "survival" objectives, which contribute instead to the stability and growth of the company.

• Three liquidity metrics
• Sample balance sheet

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Three Liquidity Metrics

The three most commonly used liquidity metrics are current ratio, working capital, and the acid-test ratio (quick ratio). All three take their input data from balance sheet entries (the full balance sheet from which these entries are taken is presented in the section below, Sample Balance Sheet). Note that "inventories" is one balance sheet category contained within Current assets. The idea is that current assets are assets that could be turned into cash relatively quickly. By this reasoning, inventories are current assets (whether raw materials inventory, work in progress inventory, or finished goods inventory), because any of the three kinds of inventories just mentioned could be turned into finished goods and then into cash quickly. However, compared to other current assets (such as Cash or Accounts receivable, inventories are the least liquid).

Similarly, Current liabilities brings a near-term focus to these metrics because this category includes only the bills the company must pay in the short term, usually defined as one year.

Balance sheet figures for the example, from the sample balance sheet, are:

Current Assets: $9,609
Current Liabilities: $3,464
Inventories: $5,986

Working Capital

Working capital is a figure in currency units (e.g., $, €, £ or ¥) showing the difference between current assets and current liabilities:

Working capital = Current assets – Current liabilities
= $9,609 – $5986 = $3,623

How much working capital is sufficient? Company management will attempt to address that question by projecting their current liabilities for the next year and the expected cash inflows for the next year.

Current Ratio

The current ratio metric is built from the same input data as the working capital metric, except that here a ratio is produced by dividing current liabilities into current assets:

Current ratio = Current assets / Current liabilities
= $9,609 / $5986 = 1.61

This company's current ratio may be cause for concern among analysts, because a current ratio value of 2.0 is a generally used "rule of thumb" requirement for healthy liquidity. (While a current ratio under 1.0 might be considered cause for alarm).

Acid-Test Ratio / Quick Ratio

The most severe liquidity test of the three presented here is the acid-test ratio, or quick ratio. This ratio is similar to the current ratio, except that the inventories figure is subtracted from current assets before performing division. The idea is that inventories are the least liquid of the current assets components:

Acid-test ratio = (Current assets – Inventories ) / (Current liabilities)
= ($9,609 – $3,464) / $5986 = 1.03

Here, too, this company's acid-test ratio might be cause for concern. Analysts generally consider an acid-test ratio of about 1.1 as a minimum healthy level.

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Sample Balance Sheet

Data for the liquidity metrics calculations above were taken from this example balance sheet:

Grande Corporation
Balance Sheet at 31 December 2011

Assets
   Current Assets
     Cash...................................... 1,369
     Short term investments.................... 137
     Accounts receivable............... 1,969
       Less allowance doubtful accts...   137
         Net accounts receivable............... 1,832
     Notes receivable short term...............    20
     Inventories
       Raw materials...................   611
       Work-in-progress................ 1,692
       Finished goods/merchandise ..... 3,664
       Operating & office supplies.....    19
         Total inventories....................  5,986
     Prepaid exp & insurance, deferred taxes..     37
         Total current assets ........................  9,609
   Long Term Investments & Funds
     Common stock held.........................   493
     Preferred stock held .....................   184
     Bonds held/sinking funds .................   364
     Other long term investments...............   419
         Total long term investments and funds......... 1,460
   Property, Plant & Equipment
     Factory mfr. equipment ........... 5,983
       Less accumulated depreciation .. 2,782
         Net factory mfr equipment. ........... 3,201
     Store/Equipment Selling assets.... 5,456
       Less accumulated depreciation... 1,292
         Net store equipment................... 4,164
     Computer systems.................. 4,721
       Less accumulated depreciation... 2,370
         Net Computer Systems................. 2,351
            Total Property, Plant & Equipment......... 9,716
   Intangible Assets
     Copyrights............................... 1,014
     Trademarks and patents...................   108
     Goodwill.................................   100
       Total intangible assets........................ 1,222
   Other Assets......................................      68
     Total Assets................................... 22,075

Liabilities
   Current Liabilities
     Accounts payable ........................ 1,642
     Notes payable, short term................    912
     Current portion of long term debt .......    130
     Accrued expenses /interest payable ......    146
     Unearned revenues........................    274
     Taxes payable / Other withholdings.......    141
       Total current liabilities.....................   3,464
   Long Term Liabilities
     Bank notes payable.......................    912
     Bonds payable & other long term liab..... 4,562
       Total long term liabilities...................   5,474

     Total Liabilities ............................... 8,938

Owners Equity
   Contributed Capital
     Preferred stock................... 3,798
     Common stock...................... 4,184
     Contributed capital excess of par. 1,457
       Total contributed capital.............   9,439
   Retained Earnings .......................... 3,698
     Total Stockholder's Equity....................... 13,137
       Total Liabilities and Equities ................ 22,075

For a complete introduction to financial metrics, including a working set of interrelated financial statements and over 100 financial metrics derived from them, see Financial Metrics Pro.

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Acid-test ratio / Quick ratio / Liquidity metrics

Three Liquidity Metrics

Sample Balance Sheet

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