Question

How is the acid-test ratio calculated, and what does it signify?

Short answer

The formula for calculating the acid-test ratio:

$\mathrm{Acid}\mathrm{test}\mathrm{ratio}=\frac{\mathrm{Cash}\mathrm{and}\mathrm{cash}\mathrm{equivalent}+\mathrm{Short}-\mathrm{term}\mathrm{investment}+\mathrm{Net}\mathrm{receivables}}{\mathrm{Total}\mathrm{current}\mathrm{liabilities}}$

The acid test ratio signifies the capability of the business entity to pay the current liabilities.

Step-by-step solution

Definition of Financial Ratios

The figures that are calculated by comparing various line items of the financial statement to arrive at a conclusive decision regarding liquidity, solvency, and profitability are known as financial ratios.

Significance

The acid test ratio is calculated using some of the current assets that can be converted into cash immediately, such as cash and equivalents, short-term investments, and net receivables. The sum of these assets is compared with the current liabilities to determine the acid test ratio.

The acid test ratio signifies whether the business entity can cover all of its current liabilities in the situation where they all become due immediately.