ACID TEST RATIO

The Acid Test ratio is a more conservative version of the current ratio. Although the two are similar, the acid test eliminates all but the most liquid of current assets from  consideration. Inventory is excluded because it cannot rapidly be converted to cash and

Untitled 1  
in a severe case inventory would end up being converted to cash in "pennies to the dollar". In many cases, prepaid expenses should also be eliminated as they either cannot be converted to cash or are for expenses incurred that are being amortized over an estimated life.

The acid test ratio gives a sense of the efficiency of a company's liquidity position and convert its accounts receivable into cash. Companies that have trouble converting accounts receivables to cash can run into liquidity problems. Because business operations differ in each industry, it is a more useful to compare companies within the same industry.
The formula for acid test ratio is:
Acid Test ratio =

Cash + Marketable Securities + Accounts Receivable / current liabilities

Many lending institutions and financing facilities like to use the acid test ratio as one of the measures of a company's management effectiveness.

Example:

Apple, Inc. 
In Millions

PERIOD ENDING 26-Sep-09 27-Sep-08 29-Sep-07
Current Assets
Cash And Cash Equivalents 5,263   11,875   9,352  
Short Term Investments 18,201   12,615   6,034  
Net Receivables 7,158   6,151   4,811  
Inventory 455   509   346  
Other Current Assets 5,188   3,540   1,413  
Total Current Assets 36,265   34,690   21,956  








 

Liabilities
Current Liabilities
Accounts Payable 8,977   8,558   6,230  
Short/Current Long Term Debt -   -   -  
Other Current Liabilities 10,305   5,534   3,069  
Total Current Liabilities 19,282   14,092   9,299  

Acid Test -

Current Assets
Cash And Cash Equivalents 5,263   11,875   9,352  
Short Term Investments 18,201   12,615   6,034  
Net Receivables 7,158   6,151   4,811  
Sum of acid test assets 30,622   30,641   20,197   
  Divided by :      
Total Current Liabilities 19,282   14,092   9,299  
  Acid Test Ratio  1.59:1    2.17:1     2.17:1    






 

 

 As can be seen, Apple continues to maintain a healthy acid-test ratio over the period analyzed. Compare this to the net working capital - what do you think? As stated in the other ratio sections, ratios used alone show only one piece of the puzzle. Multiple ratios should be calculated and reviewed to obtain a better understanding

This ratio is similar to the current ratio except that the current ratio includes all current assets inventory and prepaid expenses in the formula. The components of current ratio (current assets and current liabilities) can be used to derive net working capital