What is the ratio of acid test?
The ratio of acid test is a financial metric used to determine the ability of the company to repay its debts. It is calculated by taking over the value of all assets of the company, with the exception of stocks and the division of its obligations. The ratio of more than one suggests that the company could immediately meet all its debt obligations if the situation arose. As with other ratios, the ratio of acid tests is most effective in comparing companies with similar characteristics. Of course, a successful society can earn enough money through their daily operations to cover these debts if necessary. The balance between what society has in terms of its assets and what it owes can help determine the overall financial power of this company. For this reason, the ratio of the acid test is an excellent tool for investors in the evaluation of companies.
as an example of how to calculateThe ratio of acid tests, sometimes known as a rapid ratio, imagine that the company currently has $ 500,000 (USD) in the form of cash, receivables and investment securities. It also has obligations worth $ 400,000. The $ 500,000 distribution by $ 400,000 provides a $ 1.25 ratio. This means that if the company suddenly had to pay to all its creditors, it could do so and still have 25 percent of its assets in reserve.
It is important to note that the inventory is not included in the calculation of the acid test ratio. As a result, it differs from a similar metric known as the current ratio that uses the same formula, assets divided by liabilities, but includes reserves in the total number of assets. Many financial analysts consider the rapid ratio to be a more realistic evaluation of the company, the company could work in the worst case, because inventories often cannot be converted into cash with ease.
Given the exclusion of inventories from the formula is important for those who study the ratio of the company's acid testto evaluate compared to other companies of the same ILK. For example, retail stores, which have a much higher percentage of their assets tied in stocks, would probably have fast conditions that do not compare well with companies in industries where the inventory is not so predominant. Finding a benchmark company in a specific industry and using its rapid ratio as a base for comparison is one way to use this metric for the best advantage.