IGCSE Accounting 0452 - 6.1 Liquid (Acid) Test Ratio

Introduction

The liquid (acid) test ratio is a financial ratio that assesses a company's short-term ability to pay its current liabilities using its most liquid assets, excluding inventory.

Understanding the Liquid (Acid) Test Ratio

Unlike the current ratio, which includes inventory, the liquid test ratio provides a more conservative measure of liquidity. This is because inventory can sometimes be difficult to quickly convert into cash.

The ratio indicates whether a company has enough readily available assets to cover its immediate debts.

Formula

The formula for the liquid (acid) test ratio is:

$$ \text{Liquid (Acid) Test Ratio} = \frac{\text{Cash and Bank Balances} + \text{Bills Receivable}}{\text{Current Liabilities}} $$

Components of the Formula

• Cash and Bank Balances: This represents the actual cash held by the company in its bank accounts.
• Bills Receivable: These are amounts owed to the company by its customers for goods or services already delivered. They are expected to be collected soon.
• Current Liabilities: These are debts that the company is expected to pay within one year. Examples include accounts payable, salaries payable, and short-term loans.

Interpretation of the Ratio

The liquid (acid) test ratio is generally interpreted as follows:

• Ratio greater than 1: The company has more liquid assets than current liabilities and is likely able to meet its short-term obligations.
• Ratio equal to 1: The company has exactly enough liquid assets to cover its current liabilities. This is a marginal position.
• Ratio less than 1: The company does not have enough liquid assets to cover its current liabilities and may face difficulties in meeting its short-term obligations.

Example Calculation

Consider a company with the following figures:

• Cash and Bank Balances: $30,000
• Bills Receivable: $15,000
• Current Liabilities: $40,000

Using the formula:

$$ \text{Liquid (Acid) Test Ratio} = \frac{30,000 + 15,000}{40,000} = \frac{45,000}{40,000} = 1.125 $$

Interpretation: The company's liquid (acid) test ratio is 1.125. This indicates that the company has $1.125 of liquid assets for every $1 of current liabilities, suggesting a good short-term liquidity position.

Table Summary

Component	Calculation
Liquid (Acid) Test Ratio	$$ \frac{\text{Cash and Bank Balances} + \text{Bills Receivable}}{\text{Current Liabilities}} $$
Cash and Bank Balances	Amount of cash held in bank accounts.
Bills Receivable	Amounts owed to the company by customers.
Current Liabilities	Debts payable within one year.

Suggested diagram: A simple flowchart showing the formula with inputs and the final ratio output.