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The acid test ratio represents an in-depth accounting of a company to adequately manage the outstanding liabilities currently held by the corporation. This process does not involve taking into account all the tangible and intangible assets of the company and applying the worth to the indebtedness currently held by the organization. With the acid-test ratio, only assets that do not involve prepaid services and the worth of goods in inventory are considered as part of the evaluation. Here are some of the reasons why the application of an acid test ratio can be a good idea.
While there are several functions of the acid-test ratio, the main purpose is not to determine if the corporation has enough total assets that could be liquidated in order to pay off all outstanding debts. Instead, the idea is to determine if the company has current reasonable liquid assets to pay off the debt within terms, while still being able to maintain an ongoing operation. This is why such assets as inventories and prepaid services are not included in the factoring process.
A business that is shutting down would sell off the inventory at a reduced rate and would suspend any prepaid service agreements, but a corporation that wanted to continue operations would not be interested in using those resources as a means of securing quick cash to settle debts. In order to get an accurate picture of the state of a company that intends to continue producing goods and services, it is important to focus on the assets that are already in hand, and how well they would cover the overall debt load of the company.
A simple formula for administering the acid test ratio is to divide the quick net assets in hand by the currency value of the outstanding liabilities. For instance, a company that held current liquid assets of $1,000,000 US dollars (USD) and had outstanding liabilities of $500,000 USD would have a positive acid-test ratio of assets to debt. By the same token, a company with a high amount of debt and relatively few liquid assets would have a negative acid-test ratio, and would not be considered a good investment or credit risk. This would be the case even if the company had an inventory that would sell for more than enough to retire the debt.
Along with being a viable way to establish the financial health of the company, employing the acid-test ratio to the condition of the corporation can be helpful in avoiding future problems. If the evaluation indicates the company current is working under a negative acid-test ratio, then the time for cutting operating costs and eliminating any expenses that are not central to the ongoing life of the company can help to turn the state of the company into a positive one. Using the acid-test ratio as a way of making sure all resources of the company are being used to best advantage is an important process for businesses of all sizes, from home businesses to multinational corporations.