What the Acid Test Ratio Says About a Company's Financial Health

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The worst news investors can get is that a company whose stock they own has gone bankrupt. As cataclysmic as bankruptcy can be, there are usually warning signs that astute investors can look for beforehand in order to assess the potential for bigger financial problems down the road. One of those warning signs can show up in what's known as the acid test ratio, which is sometimes also referred to as the quick ratio.

Let's take a closer look at the acid test ratio and how you can use it to evaluate a company's financial health.

What the acid test ratio is (and what it tells you)The general purpose of the acid test ratio is to measure a company's ability to take readily available assets and use them to pay currently outstanding bills and other liabilities. The result therefore indicates whether a company has any potential immediate cash-flow issues that could cause a short-term liquidity crisis.

In order to calculate the acid test ratio, you'll need to look at a company's most recent balance sheet. To start, find how much cash and cash equivalents the company holds, then add in any marketable securities from the balance sheet. To that total, you'll then add in the amount of accounts receivable. To turn that figure into a ratio, divide it by the amount of current liabilities.

In general, the greater the ratio is, the healthier the company's immediate-term financial prospects are. If the acid test ratio is less than 1, though, it means the company wouldn't be able to pay off its current liabilities with readily available cash and other short-term assets, and it would have to take more extreme measures, such as borrowing on a longer-term basis or liquidating inventory or other assets.

Danger of the acid test ratioThe acid test ratio isn't a perfect metric, though. In particular, although a company can generally liquidate marketable securities quickly and get nearly all of its current value in exchange, turning accounts receivable into cash requires either aggressive collection activity or a sale to a third-party specialist, which will often result in a discount to the amounts customers owe. Therefore, valuing receivables at 100% of the amount owed can be misleading.

At the same time, it's rare for a company to need to pay off all of its current liabilities at once. For example, the current portion of long-term debt generally includes amounts owed within the next full year. Yet clearly, a company with a huge amount of debt due within a week is in a far more challenging position than one that has 11 or 12 months to come up with a repayment.

Moreover, the acid test ratio doesn't necessarily compare well across industries. In some types of businesses, the production process is relatively long, requiring companies to invest substantial assets in inventory, therefore leaving the amount of free cash and other liquid assets relatively low. Other businesses enjoy a greater amount of just-in-time production capacity, and that allows inventory levels to stay low and frees up more cash and liquid assets for use elsewhere.

Nevertheless, one good use for the acid test ratio is to compare a single company's results across time. If you see the acid test ratio deteriorate, it's a good early warning sign that should encourage you to take a closer look at what's happening to the company. Adverse trends won't always result in bankruptcy, but they can still give valuable information about whether the company's financial management is effective.

The acid test ratio by itself isn't a perfect indicator of future financial trouble, as it only measures one element of what is often a complex financial picture for a company. Nevertheless, by giving you a sense of how much immediate liquidity a company has, the acid test ratio adds one more data point you can use in getting a more complete picture of a company's financial health.

The article What the Acid Test Ratio Says About a Company's Financial Health originally appeared on Fool.com.

Dan Caplinger 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.