The acid-test ratio is a metric used to determine if a business has sufficient short-term assets to cover its current or immediate liabilities. This is also known as the working capital ratio precisely because the calculation ignores illiquid assets and inventory amounts. The formula is:
Acid-test ratio = (cash + accounts receivable + short-term investments) / current liabilities
For example, assume a firm has $50,000 in cash, $250,000 in accounts receivable, $100,000 in short-term investments, and $200,000 in current liabilities. The business’s acid-test ratio is:
($50,000 + $250,000 + $100,000) / $200,000 = 2
This means that the company has $2 available for every $1 in current liabilities. The higher the ratio the better. A upward-trending acid-test ratio is a sign the company’s strength is growing, while a decreasing acid-test ratio is a warning sign the company is becoming over-leveraged and getting into trouble.