Acid Test Ratio Formula

An acid test ratio, also known as quick ratio, is used to calculate whether the company will be able to meet its current liabilities with the short-term assets it has. Although working capital ratio is used for the same purpose, it includes inventories in short-term assets as well, which might not be easy to convert into cash. The acid test ratio formula, which does not include inventories is thus, a far more stricter test of determining a company’s current financial capability to meet its short-term liabilities.

Formula for Acid Test Ratio

In accounting, the acid test ratio formula is mathematically presented as follows:

Cash + Accounts Receivable + Short-term Investments/Current Liabilities

There is an alternative to this formula as well, which is:

Current Assets – Inventory/Current Liability

Example

To make it more clear, let’s take an example of a fictitious company ABC. In the balance sheet of ABC, the current assets are:

– Cash: USD 50,000
– Accounts receivable: USD 30,000
– Marketable securities: USD 5000
– Inventory: USD 30,000

Current liabilities are:

– Accounts payable: USD 20,000
– Accrued expenses: USD 15,000
– Notes payable: USD 3,000
– Long-term debt’s current portion: USD 7,000

Now, company ABC’s acid test ratio will be total current assets from which inventory is subtracted, divided by total current liabilities, i.e., (USD 50,000 + USD 30,000 + USD 5,000 + USD 30,000) – USD 30,000 / (USD 20,000 + USD 15,000 + USD 3,000 + USD 7,000) = 1.88

With the acid test ratio as 1.88, the company XYZ has USD 1.88 of short-term liquid assets to meet every USD 1 of current liabilities.

Interpretation

If the acid test ratio of an organization is less than one, it means that it does not have enough current assets to meet its current liabilities. That is why, it is very important for companies to maintain a high ratio, i.e., more than one. A ratio which is less than one or is decreasing, shows that the company is either paying bills very quickly or is collecting receivables very slowly or is unable to grow sales. A high ratio shows that the company has a fast conversion cycle and a good inventory turnover too.

Another thing that companies should consider is that in case the acid test ratio is very low, compared to the working capital ratio, it indicates that the share of inventory in current assets of the company is huge. Since inventory cannot be that easily converted to cash, the company has to be really cautious about its current financial position.

Acid test ratio formula, like most other financial ratio formulas of accounting, has its own drawbacks. Firstly, it gives no information about the cash flow timings and without this information, it is impossible to determine the ability of the company to pay liabilities. Secondly, it is based on the assumption that accounts receivable are available for collection, this however may not be true in reality for many companies. Thirdly, another assumption of the formula that a company would consume most of its current assets to pay for its current liabilities, is not possible in reality, as companies do need some working capital to carry on with its operations. Lastly, timing of the purchase of assets, payment policy, collection policy, allowance of bad debt, may vary from company to company so any comparison using acid test ratios of the liquidity of companies, might not be precise, unless and until the companies belong to the same industry.

How to Raise Money for a Business?

The capital is one of the first things that needs to be taken into consideration when one is setting out on a business venture, and there are many different sources to obtain this capital. It is not necessary to stick to one particular source rigidly; even a combination of various different sources can be used.

Anyone who is wondering how to raise money for a restaurant, a start-up, an advertising agency, or any other small-scale venture should keep these methods in mind. Approaching the right people for it is vitally important for the success of the business, and if this is not catered to properly, it will be doomed from the very beginning.

Personal Savings

This is the most obvious source of money for starting a business. If you have saved up enough money over the years, go ahead and make use of it to serve the underlying purpose. You will not be answerable to anyone, and you will not have to worry about repaying someone. If you choose this option, ensure that you are not using all your savings though. Many people neglect this option because if they lose it, they will have nothing left to live on.

Venture Capitalists

This is the next most obvious source for your initiative. Venture capitalists are professional agencies who put in venture capital into an upcoming business. What they get in return is either its share, or a share of the profits, or pretty high interest rates. It may sound like exploitation, but this is one of the best ways to get money. Venture capitalists are always looking for new and innovative business ideas that are likely to succeed.

Angel Investors

These are a refined form of venture capitalists, but many people think that they mean the same thing. Angel investors are less demanding than venture capitalists and remain with your initiative in the long run. Usually, these are someone who you would know personally, and they are simply looking for ways to get a higher return on their investment. How companies raise money depends a lot on the nature of the business and the method of entrepreneurship adopted. Angel investors also help them by providing some guidance and mentoring.

Personal Borrowings

Here is a method that should be avoided as far as possible. You can borrow money from someone you know, namely your friends, family, or other people. The problem here is that once you mix business and personal relationships, things start to get a bit sour. This is a situation that needs to be handled with great tact and diplomacy, and not everyone can manage to do that. Still, this is a method that many people consider.

Bank Loans

Another answer is to approach a bank for a small loan. With banks, you will not be required to pay a very high interest rate, but you will need sufficient documentation about the business model of your initiative. Along with that, your credit history and financial stability will also be scrutinized, in order to find if you are worthy of getting a loan. Most people would love to get it, but are simply not eligible. This is especially true for someone looking to collect the money, without owning any fixed assets.

Advertising

Here is another answer, but one that requires a suitable amount of investment and more than a fair share of patience. If you can handle the advertising of your upcoming company well, you can get more than enough money to sustain it in the long run. There are some websites that also allow you to advertise your business plan and then suit you up with a matching investor. This is a slightly unreliable method for sure, but it works wonders if one can find the right match.

Other Options

One can approach some small-business investment companies, business development commissions, life insurance companies, or a money broker. The reliability of these options will not be very high, and their demand may be exorbitant, but if you have run out of all other options, then this is something that you will need to resort to.

You should act as early as possible, in order to get sufficient capital and business financing. There is a variety of sources available, and as long as you have a great and reliable plan, you will be able to procure capital. It is not all that difficult; all you need more than anything else is faith in yourself.