ACID TEST RATIO also called as QUICK RATIO detailed analysis as below:
Definition and Significance:
Acid test ratio or commonly known as Quick Ratio measures company’s ability to pay its short-term liabilities. It’s always in line with its current or short-term cash convertible assets like Marketable Securities, Account Receivables which have good turn around ratio and off Course cash reserves.
This again depends a lot on nature of business the company into for example a Retail Chain like Walmart may have very Ratio compared to a Technology giant like Google business models and their operating margins needs to be considered, the better way of drawing a reasonable conclusion on company’s ability to meet its short-term obligations by way of Quick Ratio Is to compare it with its industry standards.
Its has its limitations when a growing company may decide to focus on growth or expansion and in such an event the assumed accounts receivables cash may be used for growth plans instead of paying its vendors or short-term liabilities and if in case some receivable are stuck because of negative business sentiments and slow growth of the economy it may play the other way is well.
More detailed analysis of all major payables and receivables in line with market sentiments and adjusting input data accordingly shall give more sensible outcomes which shall give actionable insights.
ACID TEST RATIO FORMULA: Current Assets – Inventory / Accounts Liabilities.
As we can see to calculate Acid Test Ratio Inventory gets deducted from Current liabilities reason being, Inventory is either manufactured goods or Products bought to sold in stores true in case of Retail companies. Thus, this component of Current assets shall not be convertible to cash immediately again in manufacturing companies which are into B2B business or where credit periods are longer. Same though to be given when it comes to account receivables where if some receivables are older more than its industry standard its safe to assume them as bad debts to do justice to Quick Ratio and exclude them while calculating. Some of the Current Liabilities also needs to be examined and if some of them are pending for payment for more than a year, need to check the reason for non-payments like litigation, vendor change or other aspects and take a relative figure.
Real Example of Samsung Electronics Co., Ltd. and Subsidiaries:
Figures in Thousand USD as of 31 December 2016:
|No||Current Assets||Amount||Current Liabilities||Amount|
|1||Cash and cash equivalents||32,111,442||Trade payables||6,485,039|
|2||Short-term financial instruments||52,432,411||Short-term borrowings||12,746,789|
|3||Short-term available-for-sale financial assets||3,638,460||Other payables||11,525,910|
|4||Trade receivables||24,279,211||Advances received||1,358,878|
|7||Prepaid expenses||3,502,083||Income tax payable||2,837,353|
|8||Inventories||18,353,503||Current portion of long-term liabilities||1,232,817|
|9||Other current assets||1,315,653||Provisions||4,597,417|
|10||Assets held-for-sale||835,806||Other current liabilities||351,176|
|Total current assets||141,429,704||Total current liabilities||54,704,095|
Referring the above financial inputs, we Calculate the Quick Ratio: As we can see Assets held for sale may or may not convert into cash immediately so it’s safe to exclude it along with Inventories as standard process.
Quick Ratio = 122240395 (1 to 7 + 9) / 54704095 = 2.23
In this case the quick ratio is way above standard considered good above as 1, Samsung is into multiple business and hence manufacturing is at its core driven by technology products which have high margins, we can say the quick ratio here is very comfortable. As cash and cash equivalent and Short-term financial instruments of the company itself are adequate to meet its short-term liabilities.