Acid Test Ratio

The acid-test ratio, also known as the quick ratio, is a financial ratio that measures a company’s ability to pay off its short-term debt obligations with its most liquid assets. It is a more conservative measure of liquidity than the current ratio, as it excludes inventory, which may not be easily converted into cash.

The formula for calculating the acid-test ratio is as follows:

Acid-Test Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities

Cash and cash equivalents include cash on hand, demand deposits, and short-term, highly liquid investments that can be easily converted into cash. Short-term investments include securities that will be sold or mature within one year. Accounts receivable are amounts owed to the company by its customers.

A higher acid-test ratio indicates that a company has a greater ability to pay off its short-term obligations with its most liquid assets. However, a very high acid-test ratio may also suggest that a company is not making effective use of its assets and could benefit from investing some of its excess cash into its business or returning it to shareholders through dividends or share buybacks.

Generally, an acid-test ratio of 1 or higher is considered to be a good indication of a company’s liquidity, as it suggests that the company has enough liquid assets to cover its short-term obligations. However, the ideal acid-test ratio will vary depending on the industry and the specific circumstances of the company.

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