5.2.3 Acid test ratio
The acid test ratio, also known as the ‘quick ratio’ or ‘liquidity ratio’, provides a more stringent test of a company’s ability to meet its current obligations, by excluding the least liquid current assets, inventories, from the current ratio. The acid test ratio is calculated as follows:
Below is the calculation of the acid test ratio for Remote Sensors Plc.
| 2025 | 2024 | 2023 | |
|---|---|---|---|
| £ | £ | £ | |
| Current assets | 13,298 | 15,696 | 12,160 |
| Less: Inventory | (2,056) | (2,501) | (1,860) |
| Quick assets | 11,242 | 13,195 | 10,300 |
| Current liabilities | 4,869 | 4,511 | 4,070 |
| Acid test ratio | 2.31:1 | 2.92:1 | 2.53:1 |
The purpose of calculating the acid test ratio is that business entities may not be able to readily sell their inventories, if needed. Some of the inventories might never be sold. If and when inventories are sold, they trigger a receivable which must then, in turn, be collected. Therefore, inventory cannot be regarded as a source to generate cash quickly. However, this depends on the nature of the business. For example, it might be particularly hard to sell inventories in the construction sector and the acid test ratio is a better indicator of their liquidity. The management of a company can improve the acid test ratio either by better inventory management so that its cash in hand or receivables increases, or the ratio can be improved by reducing liabilities.
The range of satisfactory acid test ratio numbers is somewhat narrower than for the current ratio, although what is a ‘safe’ number still depends on the particular business circumstances within which the organisation operates. As a rule of thumb this ratio should ideally be above one. A figure below one indicates that a business may run into difficulties when paying its current liabilities and may raise concerns about the liquidity of the company. However, as with the current ratio, many companies have an acid test ratio of less than one without running into liquidity problems owing to the nature of their business.
As noted above, looking for an acid test ratio of ‘one plus a little bit’ is alright as a starting point, but you should be a little more sophisticated in your analysis. The key question when thinking about liquidity is: ‘Does enough cash flow in on a regular basis to cover the flows out that are anticipated?’
The purpose of Activity 9 is to develop your ability to calculate and interpret liquidity ratios using real company data.
Activity 9 Practising liquidity ratio analysis
Access Next Plc accounts [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] for the year ending 2022 and 2021 and answer the following questions.
- a.Calculate the following ratios to assess their liquidity.
- i.Current ratio
- ii.Acid test or quick ratio.
Use the notes to the financial statements to retrieve more accurate or additional figures.
Use the following spreadsheet to carry out your analysis.
| Workings | 2022 | 2021 | |
|---|---|---|---|
| £m | £m | ||
| Current assets | |||
| Inventory | |||
| Current liabilities | |||
| Working capital | |||
Current ratio = Current assets/Current liabilities |
|||
Acid test or quick ratio = Quick assets/Current liabilities |
Comment
| 2022 | 2021 | |
|---|---|---|
| £m | £m | |
| Current assets | 2,407.2 | 2,288.6 |
| Inventory | 633.0 | 536.9 |
| Current liabilities | 1,208.1 | 1,196.8 |
| Working capital | 1,199.1 | 1,091.8 |
| Current ratio = Current assets/Current liabilities | 1.99 | 1.91 |
| Acid-test/Quick ratio Quick assets/Current liabilities | 1.47 | 1.46 |
Workings
Current ratio = Current assets/Current liabilities
2022 = 2,407.2/1,208.1 = 1.99
2021 = 2,288.6/1,196.8 = 1.91
Acid-test/Quick ratio = Quick assets/Current liabilities
2022 = (2,407.2 − 633.0)/1,208.1 = 1.47
2021 = (2,288.6 − 536.9)/1,196.8 = 1.46
- b.How might you interpret the changes in these ratios? Write your thoughts in the box below.
Feedback
The current ratio indicates that the company should be able to pay its current liabilities as they fall due. There was a slight increase in the current ratio in 2022 (1.99:1) when compared to 2021 (1.91:1), and no apparent liquidity problems are indicated. The quick ratio of the company remained consistent from 1.46 in 2021 to 1.47 in 2022. Since Next is a retail business and needs to maintain high levels of inventory a quick ratio of 1.47 is also good and does not indicate any liquidity concerns for the company.