Are you thinking of investing in an entity? You may want to look into its liquidity first. The acid test gauges a company’s short-term liquidity to find out whether if its short-term assets, when converted into cash, can shoulder their short-term liabilities, without compromising their inventory, within a specific period of time.

Here’s what you need to do in measuring a firm’s liquidity. Simply add all of its present assets (cash, accounts receivable, etc.), excluding assets, and then divide the answer by its existing liabilities (accounts payable and short-term debt obligations).

Look at the end result to find out if a company passes the test. If the ratio is higher than 1, the company has enough assets to shoulder its short-term liabilities. Conversely, if the ratio is lower than 1, the firm has no capacity to cover its liabilities.

Example 1

Company XYZ is a production company. Its total current asset amounts to $44,000 (that’s $10,000 in cash, $4,000 in a money market account, and $30,000 in accounts receivable). The firm has a total of $50,000 in liabilities (owed $3,500 to the independent marketing entity, $2,500 to a supplier, $4,000 on credit line at a bank, $1,500 in income taxes, and $7,000 to employees).

Now, let’s begin crunching the numbers. Divide Company’s current assets by its current liabilities. Hence, the firm’s acid test ratio is 0.88, meaning Company XYZ fails the liquidity test.

Example 2

Company ABC is a marketing company. It has a total current asset of $500,000 ($250,000 in cash and $250,000 in accounts receivable). The total liability is tantamount to $200,000 ($150,000 in taxes and $50,000 on credit line at a financial institution).

Let’s divide Company ABC’s current assets by current liabilities. Therefore, the ratio is 2.5, meaning the firm has $2.5 of liquid assets available to cover each $1.00 of existing liabilities.

Acid test is a significant tool every investor should use as it is a good determinant of a company’s liquidity or its capability to shoulder the liabilities, especially in the event of financial difficulty or bankruptcy.