Acid Ratio Vs Cash Ratio

The financial position of any company can be measured through various methods, but, one of the easiest and most efficient methods is by using the financial ratios and liquidity ratio is one such financial ratio.

Liquidity Ratio:

Liquidity of any company is defined as a firm’s ability to meet its short-term liabilities or in simple words you can say that it measures how easily a company can fulfill its obligations when they become due. So, a company’s ability to pay its short-term debts is measured using liquidity ratio which can easily be calculated by using the financial information provided in the financial statements. Liquidity ratio is further divided into three main ratios and measuring all three of them would give the analysts the right view of the company’s efficiency in terms of liquidity.

Current Ratio:

The liquidity of the company could be easily and directly measured using the current ratio. It is actually defined as a company’s ability to pay its short-term debt using its current assets. The formula that could be used to calculate the current ratio is very simple and is as follow
There are two terms which are of concern to measure the ratio i.e. current assets and current liabilities. The current assets of any company include all the assets that it possess which could be converted into cash within a period of one year such as cash, account receivables, marketable securities etc. Similarly, the current liabilities are those debts that the company has to or can have to pay within a short period of one year. We can understand this ratio with the help of an example. Let’s suppose an ABC company has this information in its balance sheet

Current Assets = $80,000 and Current Liabilities = $40,000
So, the company’s current ratio will be 2 (80,000⁄40,000)

This ratio of 2 means that the company has twice a number of assets as compared to its debt i.e. for every $1 liability, a company has $2 to pay it. The current ratio equal or greater than 1 is considered good for the company. 

Acid Ratio:

The acid ratio is also called as quick ratio and is another type of liquidity ratio. The acid ratio measures a company’s ability to pay its short-term debt with the most liquid assets that it possesses. The term liquid assets refer to all those assets that could be readily converted into cash. The current assets are mostly liquid assets with the exception of inventory that can take the time to be converted into cash. So, this makes the formula for acid ratio to be:

It is a relatively tougher measure for a company’s liquidity ability. Only the information regarding the assets that are quickly converted into cash is incorporated to find out the company’s quick ratio. For example, if a financial analyst gets the following information from a company’s balance sheet 

Cash and Cash Equivalents = $ 40,000
Accounts receivables = $ 20,000
Inventory = $ 10,000
Short-Term investment (that matures within 90 days) = $15,000
Current Liabilities = $ 25,000
Then he can easily calculate the Quick ratio as:
Quick Ratio = 3 (( 40,000+20,000+15,000)⁄25000  )

This quick ratio to be 3 is an indication that the company is financially stable as it has $3 to pay each $1 of the debt. Acid Ratio equal to or greater than 1 s considered good for the company.
Cash Ratio:

The liquidity measurement is further narrowed down by measuring the cash ratio of the company as it is the measure of the company to pay its short-term liabilities with the help of cash reserves that it possess. No other current or quick acid is involved while measuring the cash ratio. The formula for the Cash Ratio is:

From the balance sheet only these two items would be taken to calculate the cash ratio.
For example if the company’s current Cash reserves are $ 20,000 and the Short-term investments are $10,000 and Accounts receivables is $ 20,000 whereas the Current liabilities are $ 30,000

Then the company cash ratio would be 

Cash Ratio = 1 ((20,000+10,000) ⁄30,000)

The higher cash ratio is an indication of a company’s strong financial position.
These are the three kinds of liquidity ratios that should be measured in order to judge the company’s ability and efficiency in paying the short –term or current debt. These ratios are important to be checked by those who want to invest in the company.

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Liquid ratio or quick ratio used in finance

quick ratio or liquid ratio is used in finance. It basically defines the ability of a company to completely dissolve its current liabilities or short-term debts obligation by utilizing its assets and cash. The higher liquidity of a company increases its chances to cover short-term debts in case of emergency or a particular situation. A company with less than 1 quick ratio cannot payback its current liabilities. Company has to keep this ratio at least more than 1 in order to deal with the situation or insolvency or bankruptcy. Multinational companies or not so worried about these ratios as they won’t go in bankruptcy as compared to small public limited companies. This ratio is to be considered by other types of businesses as well like sole traders, partnerships, and private limited companies. Testing a company’s liquidity is obligatory in analyzing it. Short term refers to less than twelve months. The investors consider the liquid test ratio to be a great indicator of a company's performance; investors include banks and ordinary people who buy company's shares.

Imagine you invest all your money in a company and after a few months the company collapses. What will happen to your money? The only money you will be receiving is what will be left of the company after its liquidizing. In this scenario you would want to invest in a company which has adequate number of assets and money from which they can pay off their debts and give back your money.

The few formulas for liquidity ratios include:-
-Current Ratio = Current assets/current liabilities

-Liquidity= (current asset-inventories)/current liabilities

-Quick Ratio = (Accounts Receivable + Cash Equivalents + Cash)/(Accruals + Accounts Payable + Notes Payable)

-Cash Ratio = Cash and cash equivalents/ Current liabilities

-Receivable turnover ratio = Sales Revenue / average Receivables

-Avg No: of days = 365 / Receivable Turn over

-Inventory Turnover = Cost of goods sold/average inventory

When it comes to quick ratio, it does not always show the whole picture of the company. It shows the current status of the company to pay off its debts which means it will include the bills that are paid already but the ones to be paid are not included and the quick ratio will show that the company is having a good liquid ratio but in fact the future of the company is not secure.

For the better view of a company cash ratio can be used as well. In this ratio the inventory and other low level liquid assets are eliminated thus giving a good indication of the company’s ability to meet its current liabilities.

Receivable turnover ratio explains the company’s credit policy mainly. A high Receivable turnover ratio directs towards the fact that the company can collect its dues in time from its customers in time. A high ratio compared to rivalry may point that the company's credit policy is somehow at risk where the company does not supply sufficient credit capacity and might be behind on sales opportunity.

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