The ‘current ratio’ and ‘acid-test ratio’ are two financial ratios which are used to measure how easily a company could pay all its short term obligations, often referred to as current liabilities (mainly short term debt payments and accounts payable), with its short-term or current assets (cash, inventory and receivables).
Current ratio
The current ratio is also known as the ‘liquidity ratio’, ‘cash asset ratio’ or ‘cash ratio’. It is calculated as:
\(\mathrm{Current\: ratio} =\frac{Current\: assets}{Current\: liabilities}\)
For example, if ABC Company’s current assets are $100m and its current liabilities are $67m, the current ratio is 100,000,000 divided by 67,000,000 and equals 1.49 or 149%. Put simply, it means that the company has $1.49 of current assets for every dollar of current liabilities.
Obviously, the higher a company’s current ratio, the more able that company is to pay its short term obligations. Alternatively, if the current ratio is less than 1.0, the company may have problems meeting its obligations. However, what constitutes a suitable ratio varies from industry to industry.
Therefore, if you are going to use the current ratio to compare different companies (say, for investment purposes), you should only compare companies within the same industry. For example, in some industries a current ratio of 2.0 or more would be considered adequate, whereas in a different industry, that same ratio may be considered too high, suggesting that management is being overly cautious and not using its current assets efficiently.
Therefore, a current ratio should always be considered in the context of the company and its industry sector, the nature of the company’s assets, its cash flow and also its ability to borrow.
Acid-test ratio
One problem with using the current ratio for analysing creditworthiness is that a company’s current assets usually include inventory, stock or other assets that sometimes cannot be sold quickly enough to realise their full value in time to meet the short-term obligations; or, if sold quickly, may have to be sold at a deep discount.
Therefore, to measure a company’s short term financial strength, analysts sometimes use a more stringent test known as the acid-test ratio, which excludes inventory from current assets to include only ‘quick’ (ie liquid or near-cash) assets. These would include readily marketable investments and short-term accounts receivable.
This ratio is used to measure a company’s capacity to maintain operations as normal using current cash or near cash reserves in bad periods. Interestingly, the name ‘acid-test’ comes from the Gold Rush days when gold miners would immerse their gold nuggets in acid to see if they were real gold since, unlike other metals, gold does not corrode or dissolve in acid.
The acid-test ratio is also known as the ‘quick assets ratio’ or ‘quick ratio’, and is calculated as:
\(\mathrm{Acid-test\: ratio} =\frac{Current \:assets\:– \:inventory}{Current \:liabilities}\)
Using our ABC Company example (with inventory of say $29m), the acid-test ratio would be 100,000,000 minus 29,000,000 divided by 67,000,000 to equal 1.06 or 106%. This figure means that, for every dollar of current liabilities, the company has $1.06 of easily convertible assets. Again, what would be considered an acceptable acid-test ratio will vary from industry to industry.
