Historically investors have used the Acid Test Ratio (ATR) as a method of assessing how quickly a company’s assets can be turned into cash. The ATR is therefore a test of liquidity.
This post contains the following topics:
- Defining the Acid Test Ratio
- What Does the ATR Imply to the Investor?
- Why is ATR Considered an Important Measure of Liquidity to the Investor?
- Why is ATR Considered an Important Measure of Liquidity to the Supplier?
- Alternative Acid Test Ratio Calculation
- What are the Key Problems with ATR Analysis of a Company (or an Industry)?
Defining the Acid Test Ratio
This important measure of a company’s liquidity is calculated as:
Acid Test Ratio (ATR) = (Current Assets – Inventory) / (Current Liabilities))
Industry investors quote the ATR ratio as a number and not as a percentage.
What Does the ATR Imply to the Investor?
Investors will look at the relative size of the ATR compared with other organisations. This is often viewed as an important indicator of a company’s financial strength and its ability to meet short-term obligations. It excludes inventory since inventory is often viewed as difficult to sell quickly at a reasonable value.
A higher numerical number would indicate a better liquidity, when compared with another company; however detailed analysis is always needed. Investors are often quoted as saying they believe the ratio should be at least 1.0.
Why is ATR Considered an Important Measure of Liquidity to the Investor?
Many investors consider ATR the primary measure of profitability since it compares the inputs (total capital invested into the company) with the outputs (profits generated by the company).
Why is ATR Considered an Important Measure of Liquidity to the Supplier?
The ATR gives a potential supplier an indication of the organisation’s ability to pay. It is therefore standard practice for potential suppliers to quickly calculate this simple liquidity measure. Ongoing suppliers would also find this assessment useful on a regular basis.
It is worth noting that the ATR helps assess the potential situation in a bad situation, where the suppliers (creditors) were putting significant pressure on the company to pay (without allowing them the time or opportunity to realise the value of the inventory).
Alternative Acid Test Ratio Calculation
This important liquidity ratio can also be defined as:
Acid Test Ratio (ATR) = (Cash + Accounts Receivable + Short-Term Investments – Inventory) / (Current Liabilities))
What are the Key Problems with ATR Analysis of a Company (or an Industry)?
The following are sometimes quoted as potential problems with the Acid Test Ratio (ATR):
- Many investors often quote a requirement of 1 for the ATR; however this expectation will vary by industry and company, depending on the specific risks.
- It needs to be considered in context. For example comparing the ATR values over a period of time, or by comparing it with the Working Capital Ratio.
- This ratio uses balance sheet values and is therefore only a snapshot. It simply provides a picture of the situation at the close of play on one specific day.
See more financial ratios.