acid-test ratio

Acid-Test Ratio

A stringent test that indicates if a firm has enough short-term assets to cover its immediate liabilities without selling inventory. The acid-test ratio is far more strenuous than the working capital ratio, primarily because the working capital ratio allows for the inclusion of inventory assets.

Calculated by:

Notes:

Companies with ratios less than 1 cannot pay their current liabilities and should be looked at with extreme caution. Furthermore, if the acid-test ratio is much lower than the working capital ratio, it means current assets are highly dependent on inventory. Retail stores are examples of this type of business.

The term comes from the way gold miners would test whether their findings were real gold nuggets. Unlike other metals, gold does not corrode in acid, so if upon submersion in acid the nugget didn't dissolve it passed the acid test. If a company's financial statements pass the figurative acid test, you can think of it as an indication that there isn't any accounting gimmickry going on, and that its bank account actually does contain gold!

See also: Current Assets, Current Liability, Current Ratio, Inventory, Liability, Working Capital

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acid-test ratio

See quick ratio.