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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 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