Acid Test Ratio Lecture

May 20, 2024

Acid Test Ratio Lecture 📊

Introduction

  • Focus on the acid test ratio, a liquidity ratio.
  • Relevant for understanding business financial health.
  • Note: Not specified in AQA A-level business, but similar to the current ratio which is.

Liquidity Ratios

Current Ratio

  • Definition: Assesses if current assets cover current liabilities.
  • Components:
    • Current Assets: Cash, Inventory, Trade Receivables.
    • Current Liabilities: Overdrafts, Payables.
  • Purpose: Ensures the business can meet short-term liabilities.
  • Ideal Ratio: Around 1.5 to 2.

Acid Test Ratio

  • Definition: More stringent liquidity measure; excludes inventory.
  • Why Use It?
    • Cautious firms wary of relying on inventory to cover liabilities.
    • Concerns over liquidity problems and relationship strains (e.g., with suppliers, banks).
  • Formula: (Current Assets - Inventory) / Current Liabilities.
  • Components to Include:
    • Included: Cash, Trade Receivables.
    • Excluded: Inventory.
  • Ideal Ratio: Around 1.

Importance for Businesses

  • Ensures a firm can cover current liabilities without selling inventory.
  • Helps avoid fines, friction with suppliers, and maintain good bank relations.
  • Special Cases:
    • Firms with fast inventory turnover (e.g., supermarkets) may operate below a ratio of 1.
    • Large organizations may rely on their power/influence to delay payments.

Analysis of Ratios

  • Current Ratio: Acceptable range is 1.5 to 2.
  • Acid Test Ratio: Ideal is 1 - reflects enough liquidity without inventory.
  • Low Ratio Implications: Below 1 indicates potential liquidity issues and solvency risks.

Real-World Applications

  • Example 1: Supermarkets confident in quick stock turnover sustain lower ratios.
  • Example 2: Large businesses can leverage their strong supplier relationships to manage liquidity.

Conclusion

  • Acid Test Ratio: More cautious than the current ratio, reflecting a truer picture of immediate liquidity.
  • Businesses should aim for a ratio around 1 but consider their specific context.
  • Always factor in the reliability of receivables and potential defaults.
  • Link to current ratio video for further review.

Good luck with your revision! 📚