Acid test ratio
The acid test ratio is the strictest test of liquidity. The term is derived from the use of nitric acid for testing gold.
This ratio is a measure of risk, the risk of going bankrupt and failing. The risk increases as the value of the ratio falls. A value of 1.0 is considered to be satisfactory as this means that the firm has sufficient liquid assets to meets its liabilities. Much below 1.0 is generally dangerous, whilst ratios well above 1.0 may be a sign of poor cash management. A firm can be too liquid; it is then not using its resources well enough.
Be careful, though, as this ratio, like many others, is industry dependant. Look at the accounts for a major supermarket and you may find very 'poor' acid test scores, but there clearly is no real risk. They are strong companies which sell for cash, but get very good credit terms from their suppliers.
So, if you are trying to come to some conclusions about a company, get some accounts for other firms in the same industry. That will put the ratio into the correct context.
Calculation of ratios
Follow the link below to get the balance sheet for Student Computers plc and calculate the current and acid test ratios. When you have finished, follow the answer link below to see how you got on. N.B. Calculate the ratios for both years to compare them.
Perhaps now is the time to go and get some real Annual Reports and Accounts. They are free and easy to get. Write to the Company Secretary; get on the Internet, perhaps using one of the services like the one offered on the web by the Financial Times. Another useful site for accessing annual reports is CAROL. You have to register, but use of the service is free. These reports make interesting reading, especially if you pick household names.
How can a firm improve its liquidity ratios?
Mathematically, to increase a liquidity ratio, a firm must increase its current assets other than stock; reduce its current liabilities, or both.
The objective is to generate more cash, but with less outstanding short-term debts. Let's examine each in turn:
- Increase current assets - current assets are stock, debtors and cash. It is important to increase cash as a priority. This may be done through increased overdraft levels or additional loans. The firm may raise additional finance through share issues. All assets should be examined and unwanted ones sold, or turned into cash.
To improve the acid-test ratio, stock should be reduced and sold for cash. The firm may implement a just-in-time stock control system to lower tied up stock. All business activities and expenses can be examined and improvements in efficiency planned and put into action. Often, making staff redundant will reduce staff costs. Customers should be pressed to pay any outstanding accounts. Current assets should be made as liquid as possible, and increased.
- Decrease current liabilities - short-term loans and overdrafts may be rescheduled and converted into long-term loans. This will give the firm time. Dividends may be cut so as to conserve cash. Creditors can be contacted and payment terms re-organised.