Question

How does the acid-test ratio differ from the current ratio? How are they similar?

Short answer

The primary difference between the acid-test ratio and the current ratio is that the current ratio estimates the ability of the company to clear off its debts by using short-term assets. On the other hand, the acid-test ratio or quick ratio evaluates the ability of the company to clear its debts by using short-term assets excluding inventory.

The acid test ratio is similar to the current ratio as both highlight the liquidity of the company.

Step-by-step solution

Definition of Ratio

The ratio can be defined as the measure of one value or number in relation to another. A ratio can be expressed in various ways, including as a percentage, a fraction, a “times” figure, a number of days, a rate, or as a simple manner. Ratios are just signals or clues rather than the answers to complex questions about a company.

Difference between acid-test ratio and a current ratio

Acid-test ratio and current ratio can be distinguished on the following grounds:

• Current ratio is the ratio that evaluates the potential of the company to clear off its debts with the help of current assets. On the other hand, the acid test ratio, also called the quick ratio, is the ratio that excludes inventory while evaluating the liquidity of the company, as inventory is considered to be a less liquid current asset in comparison to others.

• Current ratio is computed by dividing current assets by the current liabilities, while acid test ratio is calculated by dividing quick assets by current liabilities. Here, quick assets mean current assets minus inventories.

• The working capital ratio of 2:1 is regarded as desirable, which means that there are two assets to cover each liability. Whereas, in the case of acid test ratio, a ratio of 1:1 is satisfactory. However, if the value is significantly less than 1, it implies that the company has a large amount of its cash tied up in productive assets, so the company may struggle to raise money in the short term.

• Current ratio is suitable for all types of companies, whereas the acid test ratio is suitable for companies holding a significant amount of inventory.

Similarities between acid-test ratio and a current ratio

The acid test ratio is similar to the current ratio as both are considered to be liquidity analysis ratios because they highlight the liquidity of the company. The acid test ratio is used to ascertain whether the value of the company’s short assets is capable enough to cover its short-term liabilities. Likewise, the current ratio is also used to ascertain the company’s ability to meet its short-term liabilities.