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The term “Acid-test ratio” is also known as quick ratio. The most basic definition of acid-test ratio is that, “it measures current (short term) liquidity and position of the company”. It determines whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. The acid-test ratio is far more strenuous than the working capital ratio, primarily because the working capital ratio allows for the inclusion of inventory assets.
To do the analysis accountants weight current assets of the company against the current liabilities which result in the ratio that highlights the liquidity of the company.
Acid-test Ratio = (Cash + Accounts Receivable + Short Term Investment) / Current Liabilities
Companies with ratios <1 cannot pay their current liabilities and therefore should be viewed with extreme caution. If the acid-test ratio is much lower than the working capital ratio, this means current assets are highly dependent on inventory. Retail stores are examples of this type of business.
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