GlossaryEditor
Glossary Editor
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The acid-test ratio is a method of determining the strength of a company’s assets compared to the amount of its debts. It is calculated by combining all the company’s assets, minus inventory, and dividing it by the company’s current liabilities. An acid-test ratio of greater than 1 indicates that a company could pay off all its debts immediately, if it were necessary. For example, a company that has assets of a $100,000 value and liabilities of $80,000 has an acid-test ratio of $100,000/$80,000, or 1.25. This means that the company could pay off all its liabilities immediately and still have 25% of its assets left over. Inventory is excluded from the acid-test ratio because inventory is often not immediately convertible into cash. The ratio that takes inventory into account is called the current ratio. Because inventory is not taken into account in the acid-test ratio, it is important to compare equivalent companies, rather than companies in different industries. Retail companies, for instance, hold a large amount of their assets in inventory and will consequently perform worse on the acid-test ratio than companies that are less dependent on inventory, such as service companies. The term “acid-test ratio” refers to gold mining, when gold nuggets were submersed in acid to determine if they were genuine. If they were pure gold, most acids would not corrode the metal, but if they were alloys or other metals, the nuggets were liable to dissolve, turn different colors, or show signs of corrosion.
