How is the Acid Test Ratio defined?

How is the Acid Test Ratio defined?

• A. Cash, current investments, and accounts receivable divided by current liabilities; measures the availability of liquid current assets to pay current liabilities
• B. Total assets divided by total liabilities
• C. Net income divided by average equity
• D. Current assets divided by current liabilities (excluding inventory)

Answer: (A)

The acid-test ratio is a strict measure of short-term liquidity that looks only at the most liquid assets that can be quickly turned into cash to cover current liabilities. It focuses on cash, investments that are readily marketable, and accounts receivable, because these assets can typically be converted to cash without much delay or loss in value. The ratio is calculated as (cash + current investments + accounts receivable) divided by current liabilities. By excluding inventory, which may not be readily sold or may require time and potentially discounting to convert to cash, this metric gives a tighter view of how well a company can meet its short-term obligations with its most liquid assets. This is why it’s considered a more stringent liquidity measure than the current ratio, and it’s often used by lenders to assess immediate ability to pay current debts.

The acid-test ratio is a strict measure of short-term liquidity that looks only at the most liquid assets that can be quickly turned into cash to cover current liabilities. It focuses on cash, investments that are readily marketable, and accounts receivable, because these assets can typically be converted to cash without much delay or loss in value. The ratio is calculated as (cash + current investments + accounts receivable) divided by current liabilities. By excluding inventory, which may not be readily sold or may require time and potentially discounting to convert to cash, this metric gives a tighter view of how well a company can meet its short-term obligations with its most liquid assets. This is why it’s considered a more stringent liquidity measure than the current ratio, and it’s often used by lenders to assess immediate ability to pay current debts.