Acid test ratio

Definition: How many times over a company’s Cash and Accounts Receivable are able to pay the company’s Current Liabilities. The formula: (Cash + Accounts Receivable) / Current Liabilities.

Example: NKL Corp. has Cash of $1,000,000, Accounts Receivable of $500,000 and Current Liabilities of $750,000. Its Acid Test Ratio is ($1,000,000 + $500,000) / $750,000, or 2. It can pay off its Current Liabilities two times over with its existing cash and the cash it will receive when customers pay that they owe (which is kept track of by the Accounts Receivable account).

Investeach explains: Common Current Assets include Cash, Accounts Receivable, Inventory and Prepaid Expenses. Notice that this ratio excludes Inventory and Prepaid Expenses. By subtracting Inventory, we are assuming a “worst case” scenario where our Inventory is of little value now or in the future because has become obsolete or it is very specialized, resulting in our having a hard time finding a buyer for it. We exclude Prepaid Expenses because these may not be refundable, meaning that we cannot get our money back if we want to cancel the remainder of the service we paid for but haven’t yet used.

This ratio is more stringent (ie, tougher) than the Current Ratio, which includes all Current Assets in the numerator!

Riddle me this:

1. How do we calculate the acid test ratio?
2. What is it designed to measure?
3. What is the difference between the acid test ratio and the current ratio?
4. Why might a company’s inventory not be worth the amount that its accounting records show it is?