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Difference Between Acid Test Ratio and Current Ratio
The management of any kind of company is not an easy task. Although the majority of businesses place a higher priority on their assets as a yardstick of success, liquidity is also quite crucial. You might be wondering, "What exactly is liquidity?" This refers to the rate at which an organization may turn its assets into cash. Lack of liquidity is never a good indicator for a business, regardless of how lucrative the company may be. For instance, in the event that anything goes wrong and the company is in need of some assistance, one of the first things that creditors will need to know is the company's liquidity, in addition to other aspects such as profitability.
Thankfully, it is not rocket science to determine the liquidity status of a corporation. The acid test ratio and the current ratio are both examples of methodologies that may be utilized in the process of measuring liquidity. Let's check how these two ratios are calculated, as well as the discrepancies that exist between them.
What is Acid Test Ratio?
When determining a company's liquidity, the acid test ratio, which is also known as the quick ratio, does not take inventory into account. This is due to the fact that inventory is less liquid compared to other current assets, particularly for companies operating in the retail and industrial sectors of the economy. The majority of the time, businesses in this category have considerable inventories, which are the most valuable components of their current assets. Only highly liquid assets that may be converted to cash in less than ninety days or less are considered for use in calculating this ratio.
In this calculation, cash and cash equivalents accounts receivable, and marketable securities are all taken into consideration. Accounts payable, short-term debts, and other obligations, in addition to accrued liabilities, are included in the definition of current liabilities that are used in the calculation of the acid test ratio.
To determine the acid test ratio, take the difference between current assets and inventories and divide that number by current liabilities. When compared to the current ratio, the acid test ratio presents a more favorable picture of the company's liquidity status.
Companies that have an acid test ratio that is less than one are seen to be in a stronger financial situation than those that have a ratio that is less than one. This is in comparison to companies that have a ratio that is less than one.
What is Current Ratio?
The current ratio, which may also be referred to as the working capital ratio, is a measurement of the capacity of a company to pay down its short-term commitments using its current assets. The ratio displays, on the balance sheet of a corporation, the value of the assets that may be converted into cash within a period of one year.
Receivables, cash and cash equivalents, prepaid costs, marketable securities, and inventory are all examples of current assets that might be utilized. The terms account payable, short-term debt, and accrued obligations are included in the definition of current liabilities.
The current ratio is determined by dividing the value of the current assets by the value of the current liabilities. viCompanies that have a current ratio that is lower than one have a lower level of current assets in comparison to their current liabilities. This is analogous to the acid test ratio. Because of this, it is more likely that the firm will not be able to meet its short-term commitments, which implies that creditors will view the company as a danger to their investment. Businesses that have a current ratio that is more than one are regarded as being more liquid, and they have a greater opportunity to secure financing in the event that it is required.
Difference between Acid Test Ratio and Current Ratio
The following table highlights the major differences between Acid Test Ratio and Current Ratio −
Characteristics | Acid test ratio | Current ratio |
|---|---|---|
Definition | The acid test ratio is a way of
measuring a firm's liquidity by looking
at the company's current assets and
ignoring the inventory of the
company. | The current ratio is a
measure of the liquidity of
a corporation that makes
use of the company's
current assets. |
Suitability | The acid-test ratio, on the other hand,
is appropriate for use by businesses
that keep a substantial quantity of
inventory. | The current ratio is
applicable to all different
kinds of businesses. |
Calculation | The acid test ratio may be calculated
by deducting inventory from current
assets, then dividing the result by
current liabilities. | Divide the value of current
assets by the number of
current liabilities to arrive
at the current ratio. |
Nature | When compared to other liquidity
ratios, the acid test ratio is considered
to be the most accurate one. | When it comes to
determining a company's
liquidity, the current ratio is
a more forgiving metric. |
Conclusion
The acid test ratio is a way of measuring a firm's liquidity by looking at the company's current assets and ignoring its inventory of the company. To determine it, start by taking current assets and removing inventory from the total, then divide that number by current liabilities.
The current ratio is a measure of the liquidity of a corporation that makes use of the company's current assets. To determine it, divide the number of current assets by the amount of current liabilities.
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