ACID TEST RATIO Meaning and
Definition
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The acid test ratio, also known as the quick ratio or liquid ratio, is a financial indicator that measures a company's ability to pay off its short-term liabilities immediately using its most liquid assets. It is a more stringent measure of liquidity than the current ratio because it excludes the inventory from the calculation due to its relatively lower liquidity.
The acid test ratio is calculated by dividing the sum of cash, cash equivalents, short-term investments, and accounts receivable by the total current liabilities. The resulting ratio represents the number of times a company can cover its current liabilities with its most liquid assets.
A higher acid test ratio suggests a stronger ability to pay off short-term obligations without relying on the sale of inventory, which may take longer to convert into cash. This ratio is crucial for evaluating a company's liquidity position and its ability to meet immediate financial obligations, such as paying suppliers, lenders, or employees.
Generally, a healthy acid test ratio is considered to be above 1, indicating that a company has enough liquid assets to cover its short-term liabilities. However, the ideal ratio may vary across different industries. It is important to compare a company's acid test ratio with industry benchmarks and its own historical performance to assess its financial health accurately. A decline in the acid test ratio over time may signal deteriorating liquidity and potential financial difficulties.
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