Difference Between Current Ratio and Acid Test Ratio

Key Difference – Current Ratio vs Acid Test Ratio
 

Liquidity, one of the most crucial aspects of a business, refers to the convenience of converting assets into cash. Even though the main objective of a company is to be profitable, liquidity is more important in the short term in order to run smooth operations. Both current ratio and acid test ratio are considered to be very important tools in measuring the liquidity position in the company. The key difference between current ratio and acid test ratio lies in the way they are calculated; the current ratio calculation considers all the current assets in measuring liquidity, but acid test ratio excludes inventory in its calculation.

CONTENTS
1. Overview and Key Difference
2. What is Current Ratio?
3. What is Acid Test Ratio?
4. Side by Side Comparison – Current Ratio vs Acid Test Ratio

What is Current Ratio

Current Ratio is also called the ‘working capital ratio’ and calculates the company’s ability to pay off its short-term liabilities with its current assets. It is calculated as,

Current ratio = Current assets/Current liabilities

Assets whose full value can reasonably expect to be converted into cash within the accounting year are identified as current assets (e.g. cash and cash equivalents, accounts receivables, inventory, short-term investments) and short-term financial obligations whose settlement is due within the accounting period are referred to as current liabilities (e.g. accounts payable, tax payable, bank overdraft). Therefore, the current ratio expresses current debt in terms of current assets.

The ideal current ratio is considered to be 2:1, meaning that there are 2 assets to cover each liability. However, this can vary depending on the industry standards and company operations. Some financial experts even argue that there should not be such an ideal ratio. Having a very high current ratio is also not favourable as this means,

• Company has an excess cash and cash equivalents that can be invested to make short-term returns
• Company is holding significant inventory, thus facing related cost such as holding cost
• Receivables take longer to pay debts owed to them, meaning cash is tied up unnecessarily

If a company borrows significantly to pay off its debt, this is not a very sustainable method in the long run since the company will be highly geared. The need to have an appropriate mixture of debt to equity is essential. Payments on current liabilities are crucial as they are due within the upcoming financial year and on time payments are essential in order to maintain healthy relationships with stakeholders.

Figure_1: Cash is the most liquid current asset.

What is Acid Test Ratio?

Acid test ratio is also referred to as the ‘quick ratio’ and is quite similar to the current ratio. However, it excludes inventory in its calculation of liquidity. The reason for this is that inventory is generally a less liquid current asset compared to others. This is particularly true with manufacturing and retailing organisations since they hold significant inventory, which is often their most valuable current asset. Acid Test Ratio is calculated as,

Acid test ratio = (Current assets – Inventory)/Current liabilities

The above ratio provides a better indication of the liquidity position compared to the current ratio. The ideal ratio is said to be 1:1. However, the accuracy of this ideal is considered to be questioned by financial experts.

Figure_2: Inventory is the most valuable current asset in the retail industry.

What is the difference between Current Ratio and Acid Test Ratio?

Reference:

“Current Ratio | Formula | Analysis | Example.” My Accounting Course. N.p., n.d. Web. 02 Feb. 2017.

Folger, Jean. “What are the main differences between the current ratio and the quick ratio?” Investopedia. N.p., 02 Sept. 2014. Web. 02 Feb. 2017.

“Ideal Current Ratio | Working Capital Ratio | Sana Securities.” Sanasecurities. N.p., n.d. Web. 02 Feb. 2017.

Image Courtesy: Pixabay

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