Current Ratio vs Acid Test Ratio

The acid test ratio and current ratio both assess a company's ability to pay off its debts, but they differ in their calculation and the assets they consider. The acid test ratio, or quick ratio, is more conservative, including only assets that can be converted to cash within 90 days, excluding inventory. In contrast, the current ratio includes all current assets, including inventory, considering a time frame of one year.

The determination of a company’s business success is determined by several benchmarks and measures. These are vital to learning about how well companies are functioning related to their operations and financial health. Some of the metrics used to determine a company’s success related to the liquidity of its assets are the current ratio and the acid test ratio.

The acid test ratio, also called the “quick ratio”, determines whether the value of any company’s short-term assets is sufficient to manage its short-term liabilities. The acid test ratio is often compared to the current ratio and is found to be the more stringent measure of the two. This is because the acid test ratio excludes the inventory from the present asset calculation.

Learning about the acid test ratio and the current ratio is essential for investors, especially those who wish to decide on investment in companies on the stock market. This article attempts to explain the two concepts and highlight their differences.

What is the acid test ratio?

When you want to measure the liquidity of any company, you can use several metrics to do so. Some of the metrics used are the current ratio and the acid test ratio. These ratios and metrics are relevant as they help business owners measure their own company’s liquidity and offer a measure of its operational and financial success. Such metrics also help investors who wish to find out whether the investment in a company, through stock investment or mutual fund schemes, would be potentially lucrative.

Speaking of one of these metrics, the acid test ratio, or the quick ratio, it is important to define, to know how it differs from other metrics that measure asset liquidity in a company. The acid test ratio is a financial analysis measure that calculates a company’s liquidity, or rather a company’s ability to use its “quick assets” or near assets to cover any immediate liabilities. The acid test ratio does not account for inventory in its calculation. This is because inventory is less liquid relative to other current assets, specifically for those companies that operate in the industrial or retail sectors of the economy.

While learning the difference between the current ratio vs the acid test ratio, it is important to note that companies consider only highly liquid assets that can be easily converted into cash within 90 days when calculating the acid test ratio. Furthermore, in such a calculation, accounts receivable, cash and cash equivalents, and marketable securities are all included. In terms of a company’s liabilities, short-term debts, accounts payable, and other obligations, with accrued liabilities, comprise the definition of current liabilities used in the acid test ratio calculation.

What is the current ratio?

To understand the difference between the current ratio and the acid test ratio, you must learn about the current ratio and some of its aspects. This is important if you are investing in direct equity or mutual fund schemes through any platform, like say, the Bajaj Finserv Mutual Fund Platform. As mentioned earlier, certain metrics like the current ratio give you a clue about certain aspects of a company before you invest in its stock. This can help you in your investment decision-making processes.

Let’s have a look at the current ratio. The current ratio is also called the “working capital ratio”. The current ratio is a metric that tells you about the ability of a company to settle its short-term financial obligations using the assets it holds currently. On the balance sheet of a company, the current ratio shows the asset value that can be transformed into cash in a year.

In understanding the difference between the current ratio and the acid test ratio, it is important to know what components of a company’s aspects are taken into consideration while calculating this metric. In the calculation of this metric, cash and cash equivalents, receivables, marketable securities, prepaid costs, and inventory are all included as current assets of a company. In terms of current liabilities, short-term debt, accounts payable, and accrued obligations comprise the definition of the company’s current liabilities.

Difference between the current ratio and the acid test ratio

The table below shows the key differences between the current ratio and the acid test ratio:

Parameters	Current Ratio	Acid Test Ratio
Definition	The current ratio is a metric that expresses the liquidity of a company and makes use of the firm’s current assets.	The acid test ratio is a measure of a company’s liquidity and is arrived at by considering the firm’s current assets but excluding its inventory.
Suitability	The current ratio applies to different types of companies.	The acid test ratio may be applied to those firms whose inventory is substantially high.
Calculation	The current ratio is arrived at by dividing the value of the company’s current assets by the value of the company’s current liabilities.	To arrive at the acid test ratio, you have to subtract the inventory from the current assets and then divide the result by the value of current liabilities.
Nature	The current ratio determines a company’s liquidity, but not in a strict sense, and is more forgiving in nature.	The acid test ratio, relative to other liquidity ratios, is quite stringent in its considerations and hence, more accurate.

Understanding acid test ratio vs current ratio with an example

If you are considering a stock investment or investing in mutual funds, knowing about the liquidity ratios of a company is crucial. Ratios let you know about the company’s financial standing and help you decide whether an investment potentially results in positive outcomes. Learning about the features of the current ratio vs the acid test ratio is imperative whether you are already an investor or want to make your way into the investment domain. Here are examples of the acid test ratio and the current ratio to help you grasp the metrics better:

Example of current ratio

If a company called Company Butterfly has current assets in the value of Rs. 1,00,000 and its current liabilities are at Rs. 1,50,000, by using the formula to calculate the current ratio, the current ratio = 1.5. For this company, the ratio means that the company is only a little bit out of trouble but is not in a good place either. With a current ratio = less than 1, there are fewer current assets than liabilities, and this translates to a risk for shareholders and creditors. In this example, the current ratio stands at 1.5 which is a little on the high side, but after the settlement of the current liabilities, the Company Butterfly may find itself in the danger zone.

Example of acid test ratio

Let us say that a Company Dragonfly has an acid test ratio of 1.1. This means that this company depends on inventory more heavily than any other company's current asset. This may not mean that the company is financially unsound as it has a high amount of inventory.

Current ratio and acid test ratio - Which is better?

Determining a company’s liquidity by calculating the acid test ratio or the quick ratio makes decision-making in investment easier. However, which ratio is a better indicator of a company’s liquidity and hence, its potentially sound business position? When considering the ratios to find out about liquidity, the ratio you may choose to make calculations depends on the company you wish to evaluate for its liquidity and the time horizon you are looking at. For instance, the acid test ratio is calculated with the use of fewer variables relative to the current ratio, and its value indicates a company’s short-term financial status.

In case you are concerned about the coverage of liabilities and debts in 90 days, then the acid test ratio may prove a better way to calculate a company’s liquidity. Overall, the acid test ratio appears to be lauded as the better of the two ratios, but it is worth noting that in comparing the current ratio and the acid test ratio, the current ratio may prove to be more advantageous in some industries. For instance, excluding the inventory while calculating the acid test ratio for a supermarket chain (in which the inventory is moved rapidly) may not give you an accurate idea about the supermarket chain’s liquidity or financial health. Here, the current ratio may prove more useful.

Conclusion

Deciding to use the current ratio and the acid test ratio depends on the company whose assets must be calculated. You also have to account for the time within which calculations must be made to determine liquidity and a company’s financial well-being. In different companies, ratios may be prone to change and these may not give you accurate results on which financial decisions must be based.

Investing is not a daunting task in the digital world we live in today. Furthermore, as stock investment and mutual fund investment are becoming popular investment avenues to grow your wealth, there is enough material for you to study to make sound decisions about the companies you wish to invest in. Metrics are just one way to determine the financial health of companies, but you can do some research with adequate resources at your fingertips.

If you are interested in mutual fund investment, the very easily navigable and useful Bajaj Finserv Mutual Fund Platform (more than 1000 mutual fund schemes to choose from), along with investment calculators to base your decisions on according to your unique financial preferences and risk profile. Get a head start on investment by beginning with a mutual fund and making your way into the exciting world of financial empowerment.

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