How to Calculate Acid-Test Ratio: Overview, Formula, and Example

How well can current assets cover current liabilities?

Reviewed by Amy Drury

The acid-test ratio (ATR), also commonly known as the quick ratio, measures the liquidity of a company by calculating how well current assets can cover current liabilities. Put simply, it determines how well a company’s short-term assets can cover its short-term debts. As such, this ratio uses only the most liquid current assets that can be converted to cash in a short time.

Key Takeaways

• The acid test involves assessing a company’s balance sheet to see whether it has enough funding on hand to cover its current debt.
• It is seen as more useful than the often-used current ratio since the acid test excludes inventory, which can be hard to liquidate quickly.
• In the best-case scenario, a company should have a ratio of 1 or more, suggesting the company has enough cash to pay its bills.
• Too low a ratio can suggest a company is cash-strapped while too high a ratio could mean a company is sitting on cash.

What You Need to Calculate the Acid-Test Ratio

All of the information necessary to calculate the acid-test ratio can be found on a company’s balance sheet and includes the following: 

Current assets are any assets that can be converted into cash within one year while current liabilities are a company’s debts or obligations that are due within 12 months.

Calculating the Acid-Test Ratio

The ratio is calculated by totaling cash and equivalents, accounts receivables, and marketable investments, and dividing the total by current liabilities as shown below:

Interpreting the Acid-Test Ratio

The acid-test ratio is a conservative liquidity measure because it doesn’t include all of the items used in the current ratio or the working capital ratio. The current ratio measures a company’s ability to pay short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables).

The acid-test ratio may also be impacted by other factors, such as how long it takes for a company to collect its AR, the timing of asset purchases, and how it manages its bad debt allowances.

Companies should ideally have a ratio of 1.0 or greater, meaning the firm has enough liquid assets to cover all short-term debt obligations or bills. When a company has a ratio of 1.0, it means that it has $1 in current assets for every $1 of current debt that it owes.

It’s important to compare acid-test or quick ratios of companies that are in the same industries. This gives you a better basis for your analysis. Keep in mind, though, that some tech companies may have high acid-test ratios, which isn’t necessarily a negative. Rather, it indicates that they have a great deal of cash on hand.

Note

Firms with a ratio of less than 1 are short on liquid assets to pay their current debt obligations or bills and should be treated with caution.

Because the acid test is a quick and dirty calculation, other ratios that include more balance sheet items, such as the current ratio, should be evaluated as a more comprehensive check on liquidity if the acid test appears to fail.

Example of the Acid-Test Ratio

Consider Tesla’s (TSLA) balance sheet for Q1-2024.

The information we need includes Tesla’s Q1 2024 cash & cash equivalents, receivables, and short-term investments in the numerator and total current liabilities in the denominator.

Cash & equivalents total $26.86 billion + $3.89 billion in receivables = $30.75 billion (there are no short-term investments listed). Current liabilities total $29.45 billion.

The acid-test ratio for TSLA in Q1 2024 is $30.75 ÷ $29.45 = 1.04

This value is slightly over 1.0, indicating that Tesla is liquid enough to meet its short-term financial obligations.

What Is the Difference Between the Acid-Test Ratio and the Current Ratio?

The acid test or quick ratio only includes the most liquid current assets in the numerator. The current ratio, on the other hand, uses total current assets. These include additional items like inventories that may not be as liquid.

What Does the Acid Test Tell You?

The acid test provides a back-of-the-envelope calculation to see if a company is liquid enough to meet its short-term obligations. In the worst case, the company could conceivably use all of its liquid assets to do so. Therefore, a ratio greater than 1.0 is a positive signal, while a reading below 1.0 can signal trouble ahead.

What Is the Difference Between Liquidity and Solvency?

Liquidity corresponds with a company’s ability to immediately fulfill short-term obligations. Ratios like the acid test and current ratio help determine a firm’s liquidity. Solvency, although related, refers to a company’s ability to instead meet its long-term debts and other such obligations. A company may be illiquid but solvent, for example, or vice-versa.

The Bottom Line

No single ratio will suffice in every circumstance when analyzing a company’s financial statements. It’s important to include multiple ratios in your analysis and compare each ratio with companies in the same industry.