What is Acid Test Ratio - Definition - Formula - Example - Interpretation - Importance

Acid Test Ratio is used to measure the Liquidity position of a business. How much a liquid asset a firm has and utilize to overcome its short-term obligations or expenses incurred on daily working hours. This ratio is also known as Quick Ratio. This ratio helps the company in measuring its liquidity position in order to meet Cash requirements of business and hence maintain Working Capital of the business in an effective way.

Acid Test Ratio Formula & Calculation

It is calculated as:

Acid Test Ratio = Current Assets - Closing Stock - Prepaid Expenses / Current Liabilities X 100

                          = Quick Assets / Current Liabilities X 100

Example: if Current Assets of the company is Rs. 500000 where Closing Inventory is Rs. 50000 and Prepaid Expenses are Rs. 30000, then Quick Assets = 420000 And Current Liabilities are Rs. 300000. Now, we can find Acid Test Ratio by putting the value of Quick Assets And Current Liabilities applying the above Formula as shown below:

  = 420000 / 300000 X 100

  = 1.4%

Interpretation / Analysis of Acid Text Ratio

The above answer i.e. 1.4% shows that the for Rs. 1 amount of Quick Asset, the company has .4 Paisa to meet its current obligations, so the company can easy meet its current obligations.

Usually, if the Acid Test Ratio is more than 1, then it is favourable ratio of a company depending upon the industry in which the company is operating. But a company must have enough Quick Assets to meet to its daily expenses to operate effectively.

Importance / Significant of Acid Test Ratio

1. The investors are interested in this ratio in order to check the liquidity position of the company and invest in it to get fair return on their investments.

2. This helps the company in measuring Profitability and hence Cash can be used to make Payments and investments for different Projects.

So, we can say that Acid Test Ratio shows the liquidity position of the business and valuable for the company to meet short-term obligations in order to operate the business effectively.