Acid Test or Quick Ratio
Since certain current assets (such as inventories) may be
difficult to convert into cash, we may want to modify the Current Ratio. Also,
if we use the LIFO (Last In First Out) Method for inventory accounting, our
current ratio will be understated. Therefore, we will remove certain current
assets from our previous calculation. This new ratio is called the Acid Test or
Quick Ratio; i.e. assets that are quickly converted into cash will be compared
to current liabilities. The Acid Test Ratio measures our ability to meet current
obligations based on the most liquid assets. Liquid assets include cash,
marketable securities, and accounts receivable. The Acid Test Ratio is
calculated by dividing the sum of our liquid assets by current liabilities.
EXAMPLE - Cash is $ 5,000, Marketable Securities are $
15,000, Accounts Receivable are $ 40,000, and Current Liabilities are $ 80,000.
The Acid Test Ratio is ($ 5,000 + $ 15,000 + $ 40,000) / $ 80,000 or .75. We
have $ .75 in liquid assets for each $ 1.00 in current liabilities.
