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Ratio Analysis: The Acid-Test Ratio

The first liquidity ratio we examined in digesting Axel Tracy's book, "Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet," was the current ratio. It provides an indication of a company's ability to pay current (or short-term) liabilities with current (short-term) assets.


"Current" means assets that can be converted to cash within 12 months, but of course, some current assets are more liquid than others. Cash and the so-called "cash equivalents" obviously are available quite readily, while other assets such as prepayments may not be converted so quickly. Along with cash and cash equivalents, other readily available funding sources are short-term investments and short-term receivables.

When only these cash-like assets are considered, we are dealing with the "acid-test ratio," or as it's also known, the "quick ratio". Tracy called the acid-test ratio "stricter" than the current ratio. "In other words, it's meant to be a tougher test, and if the business 'passes' the tougher test, then in theory you can sleep a little easier at night."

This is the formula for calculating the acid-test ratio:


"(Cash & Cash Equivalents + Short-Term Investments + Current Receivables) / Current Liabilities"



All the input data for this formula comes from the Balance Sheet.

Note how specific the first half of the formula is and how it defines which line items from the Balance Sheet can be included. The second half is the same as that for the current ratio.

GuruFocus users will see this metric listed as the Quick Ratio in the Ratios section of the Summary page, just below the Current Ratio. This screenshot shows the Quick/Acid-Test ratio for Colgate-Palmolive (NYSE:CL):

The two adjacent, colored bars show the firm's quick ratio in relation to its industry peers and to its own history. Clicking on the ratio name brings up a page of other quick ratio information, including details about the industry peers and the company's history.

Whether called the quick ratio or the acid-test ratio, the result is the same: A number that tells you how many times the company can cover current liabilities with cash, cash equivalents, short-term investments and current receivables. Generally, the higher the ratio the better, and a rule-of-thumb is that we should invest only in firms with an acid-test ratio of 1.0 or higher.

However, as we note in the image above, Colgate-Palmolive has a ratio of just 0.78, below the guideline of 1.0. As was the case with Proctor & Gamble (NYSE:PG), we need to consider context; Colgate-Palmolive is a strong company with a long successful history, so it could easily borrow whatever it needed in the exceptionally rare event that it might have to pay off all its current liabilities immediately.

Tracy had this warning: "The Acid-Test Ratio suffers from similar drawbacks to some liquidity ratios (as mentioned both in the current ratio section and below), but ultimately this ratio should not be used to draw wide conclusions about the overall success or efficiency (for example) of an organization, it is simply a pure measure of a business' ability to meet its debts when they fall due in the near-term."

If the acid-test ratio increases over time, it usually suggests the business is getting stronger and its liquidity is increasing. This arises out of the fundamental business principle that the only reason companies can be forced out of business is because they cannot pay their bills.

It also reduces the odds that a company will be forced to liquidate long-term assets to keep up with its liabilities. According to Tracy, it also means a company is less likely to sell extra shares to raise cash, avoiding dilution of the existing stock (dilution of shares makes them less valuable).

Turning to drawbacks, he observed that investors need to distinguish between short-term financial snapshots and an overall business strategy. "This is also where a problem in this ratio lies; business decisions that are good for the Acid-Test Ratio may not necessarily be good for the business."

Putting in another way, the author noted that the acid-test ratio provides a measure of the risk involved in an investment but does not consider the reward side of it. Once again, he pointed out that having a balance sheet with lots of highly liquid and low-return assets may boost the acid-test ratio, but doing that may be simply the equivalent of putting money in a bank account. Successful businesses use the funds with which they are entrusted to grow shareholder's capital much more quickly than the rate of inflation.

Tracy concluded by adding that liquidity metrics, such as the acid-test ratio, are about risk and consequently more important to banks and creditors than to investors:


"This book is about business analysis, and not risk management. It is banks, and not us, who will probably focus most on measures such as this one. They will assess credit risk; they may use ratios like the Acid-Test Ratio in debt covenants and other conditions. But when it comes to business analysis in a generally secure business, this ratio should be used as a safety backstop and not a launch pad for analysis."



Conclusion

The acid-test ratio, like the current ratio, is a liquidity measure for estimating the ability of a business to meet its current liabilities. The higher the acid-test ratio, the lower the likelihood it will go bankrupt or take drastic measures such as selling off long-term assets.

The acid-test ratio is stricter than the current ratio because it recognizes that not all current assets can be quickly and easily be converted into cash. Specifically, it restricts the asset side to cash, cash equivalents, short-term investments and current receivables.

This liquidity ratio is a risk-assessment metric and may not necessarily align with the broader business strategy of a company, so its limitations should be recognized during analysis.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.