What the Acid Test Ratio Can Tell You

By Markets Fool.com


Source
: LendingMemo.com via Flickr.

Continue Reading Below

The acid test ratio is a balance sheet-based financial measure designed to help you judge how well a company can cover its short-term obligations. It is considered a stringent measure of the company's ability to cover those obligations, as it only considers cash and items that can quickly be turned into cash with very little friction costs.

Indeed, the ratio's stringency is evident in the history of its name. The "Acid Test" refers to a test used by early gold miners to check to see if metal they found was really gold. Gold doesn't corrode from most acids, so submerging a discovered metal in acid helped determine whether it was really gold. The implication is that if a company passes the financial acid test ratio, it's essentially the financial equivalent of being "as good as gold."

How is the Acid Test ratio calculated?
The Acid Test ratio is calculated as follows:

What makes it such a stringent ratio is that list of measures in the numerator.

Continue Reading Below

  • Cash can be directly used to pay off current liabilities
  • Accounts receivable represents money owed to the company from its customers for sales that have already been completed. While not directly cash, it represents a very strong claim on cash expected to be paid to the company in the very near future.
  • Short-term investments are investments -- frequently in high-quality bonds -- with maturity or other expiration dates within a year.While not quite cash, the near term to maturity helps provide a strong likelihood they can be converted to cash at nearly their maturity value should cash from those investments be needed to cover current liabilities.

As a contrast, less stringent ratios include short-term assets like inventories -- products and materials the company could sell or plans to sell, but hasn't sold. Those are tougher to convert to cash than the assets used in the Acid Test ratio, and more likely to need to be sold at a discount if the company finds itself in a cash crunch, needing to raise cash quickly to pay its bills.

What's a good level for the Acid Test ratio?
The ideal result of the Acid Test is somewhere near a "Goldilocks" level -- not too high, and not too low. A ratio that's too high is a sign that the company may be managed too conservatively, and thus be not earning a strong enough return on its balance sheet. On the flip side, a ratiothat's too low is a sign the company is at riskof falling victim to another credit freeze, like the one that took place in 2008.

Sources differ on what's "good," and levels that look good vary by industry. Many retailers, for instance, have lower Acid Test ratios than other industries because many of their short-term assets are based on inventories ready for immediate sale, and inventories aren't counted in the Acid Test ratio. Calculating the Acid Test ratio for Walmart, for instance, based on its most recently reported balance sheet, would use the following numbers:

  • Cash: $7,759,000,000
  • Receivables: $5,813,000,000
  • Short-Term Investments: (None listed)
  • Current Liabilities: $69,624,000,000

As a result, Walmart's Acid Test ratio would calculate as: ($7,759,000,000+$5,813,000,000+0)/$69,624,000,000 = 0.1949.

On the surface, that number looks like it indicates Walmart might face challenges to pay off its short-term liabilities.The reality is that Walmart also carries over $46,000,000,000 in inventories not counted in the Acid Test, most of which it has available for sale every day in its stores. In reality, Walmart's overall credit rating is an incredibly strong AA, the second highest available rating, indicating it is viewed as having very low risk of being unable to pay its creditors.

Used in context, the Acid Test ratio is a solid test of balance sheet strength
Despite the strictness associated with ignoring inventories the way it does, the Acid Test ratio is a useful test. It's useful for comparing companies' balance sheet strength within a given industry, and as part of a broader analysis to help to figure out what financial tools the company has to deal with a credit crunch. Just be sure to consider its results in the context of a broader picture of a company's operations and industry, and within that context, whether it seems too high, too low, or Goldilocks perfect.

The article What the Acid Test Ratio Can Tell You originally appeared on Fool.com.

Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.