[Music] hi there welcome along to taking the busyness revision to tour going to have a look at the acid test ratio it's a liquidity ratio first thing we'll tell you about it is that if you are an a QA a-level business student studying the new specification this ratio is not actually on your specification but we'll put a link up in the corner to our video on the current ratio which most certainly is on your specification so we'll take a little look at this one the reason why we calculate the acid test ratio because we already have a liquidity ratio we've got the current ratio and the current ratio balance is up the value of a business's current assets like it's cash its inventory or its stock and its trade receivables which is funds that's owed to it by customers where the payment hasn't come through yet balances up the value of those current assets against our current liabilities our overdraft and our payables do we have enough in current assets to cover all of the current liabilities that we've got is the value of our cash and our receivables and our inventory sufficient enough to cover the value of our overdraft and our payables and any other current liabilities that we might have and on the face of it that sounds like a good ratio but some funds are very cautious some firms are so sensitive to the fact that they may get themselves into liquidity problems and not be able to pay their debts some firms are almost paranoid by the prospect that they might have debts that form due and they don't have the cash or other current assets to be able to pay those debts because they don't like the nasty consequences that come along with that they don't like the friction that it might create with their suppliers they don't like the fines or late fees that they might have to incur they don't like the tensions that they might that might cause between them and their banks in the forms of overdrafts so firms might be very very sensitive to the prospect of not being a to honor their current liabilities now when they look at their current assets they're a little bit cautious about whether all of these current assets can be relied upon to pay off current liabilities that cash is absolutely fine cash is king if you've got enough cash to cover the value of your current liabilities they knew my friend are absolutely golden but where some managers are very cautious is particularly surrounding inventory and some firms are a little bit wary of relying on being able to sell inventory quick enough to cover the cost of all their current liabilities so we have a second ratio it's known as the acid test ratio the formula to calculate is the same as the current ratio we take out current assets and we divide it by our current liabilities but when we're totting up our current assets with the acid test ratio we generally leave the value of inventory out of the equation so we're just adding together the value of a cash and the value of our trade receivables that's money that's owed to us by customers that's going to be coming in soon we just take those two current assets disregard the value of our inventory to see whether we are still a solvent organization do we still have enough just in cash and receivables to cover the value of our current liabilities now because we've taken inventory out of the equation with this ratio what constitutes our pleasing or an acceptable ratio is slightly different with the current ratio and want to be around about the one point five to one range maybe going as high as two to one because we take an inventory out of play now there's an acknowledgement that the acid test ratio is going to be lower when we're not including stock as one of the things that we're going to use to pay a current liabilities with we're not going to have such a high ratio this time the asset test ratio the golden number is one we would like to have a ratio around about one one a little bit higher is fine because remember we're still making the assumption that all of our trained receivables will come in and we know that's not always the case there's always customers that might default on payments not pay up might have bad debts in the organization but a ratio of around one to one means that the value of the business is current assets are broadly equal to the value of its current liabilities in other words we've got enough in cash and receivables to cover the debts that we have in terms of overdrafts and trade payables to our suppliers now as with the current ratio we don't want this ratio to be too hard we don't be taking too much cash and setting it aside to pay off our debts but again as with the current ratio if the answer we get on our calculator is lower than one to one if it starts with a zero if it's naught point eight to one or point six to one nor point four to one then that means that this organization has less set aside in cash and trade receivables then it does owe to other firms or organizations in terms of overdrafts and trade payables so that means that the firm is technically insolvent and it is vulnerable to liquidity problems because if all of the firm's debts fell due during the same period then this fund does not have enough in cash and enough in trade receivables to gather together to pay all of these debts with so some people are going to go unpaid well the business is going to have to look at trying to restructure debts or try and delay payments particularly to its suppliers or the businesses left on a scratch around trying to bring other sort of short-term finances into the organization in order to try and remain solvent and pay its debts which is a headache that businesses always try to avoid so with the asset test ratio it's more cautious than the current ratio it's a true a measure of a business's ability to pay its debts perhaps particularly for those firms that might not expect to turn over their stock as quickly as some others might the golden number is a ratio of one to one with Ghana ratio of one to one or slightly higher it means we've got enough and current assets to pay our current liabilities but we've just got to raise that question mark people don't often raise this question mark is we still got that element of doubt about receivables and if too much of our ratio is made up of receivables versus cash which perhaps also factored in that not all of these receivables might get paid some of our customers may default on their payments to us and so the firm may still experience liquidity problems the other thing was perhaps bring to the table is there's many large organizations now that are very very happy to operate with acid test ratios of lower than one to one in some cases significantly lower than one to one there's two reasons why firms might be prepared to do that number one they are confident in their ability to turn over stock quickly you might an organization like a fast food restaurant or a grocery store a supermarket they're confident that they can get stock out of their business quickly enough turned into cash fast enough in order to be able to rely on using the value of inventories to pay off their current liabilities second reason why some firms may be happy to operate with a ratio of less than one to one is purely because they are confident in the size and the strength and the power of their organization that if they did ever get into any liquidity problems and it looks like they couldn't raise enough and current assets to pay off their current liabilities they're confident that their power and their strength and their importance to their suppliers would allow them to get out of that situation if you imagine a large supermarket was perhaps in a situation where it didn't have enough current assets to perfect current liabilities a supermarket would be confident enough that it would be way more powerful as an organization than some of its smaller suppliers and so it would be able to strike agreements with them delay payments to them till the time when more cash is in the organization and it can carry on operating quite freely so firms are particularly large in size or firms are confident that they can turnover stop very quickly maybe prepare to operate with a ratio of less than one to one when it comes to the asset test ratio there is that's our second look at this ratio don't forget that we've put a link up to the current in the top corner of the screen there until next time good luck with your revision you you