Acid ratio

Acid ratio refers to the figure which results from an acid test. It may also be referred to as a quick ratio. This is used as an indication of how capable a company is of paying its liabilities. To compute for this, it is necessary to have data on the money which is currently available to the company. This is then combined with accounts receivable and short-term investments. Current assets are considered without including inventory. The included items, taken together, are then divided by the total amount of current liabilities. If the result is less than 1, it is a clear indication that the company is not capable of paying for its current liabilities. This is viewed as a warning sign to creditors and investors.

On the other hand, the working capital ratio, which is otherwise known as the current ratio, is an indicator of the company’s ability to pay its short-term liabilities, while also including inventory in the computation for current assets. As with the acid ratio, the higher the ratio is, the better. In the same way, a ratio lower than one is regarded as a negative sign, as it shows that the company has not effectively turned its products or services into cash.

Knowing both the acid ratio and working capital ratio of a company can give one better insight into how the business of the company operates. For example, if the working capital ratio is shown to be higher than the acid ratio, it is a good indication that inventory plays a very important role in the computation for assets.