ABC of Accounting – Accounting Ratios – Part 2

Accounting Ratios – Part 2

We continue our blog on accounting ratios highlighting what you should consider when looking to invest in a company and what investors will study should they wish to invest into yours.

The Quick Ratio/Acid test

The Quick ratio sometimes referred to as the ‘acid test’. This is commonly used to test a company’s liquidity, in other words do you have enough cash or liquid assets to pay your immediate/short term creditors.

This is calculated by taking your current assets, these being any current asset that is either cash or can be converted into cash pretty much immediately, so cash in the bank and any receivables, money owed to you by yours customers, any prepayments you may have made less your inventory. Inventory in most scenarios would not be a consideration as this can take a lot longer to liquidate or sell.

Once this figure has been established, this is then divided by your current liabilities. Your current liabilities consist of short term financial obligations such as Accounts receivable or Trade creditors (suppliers), VAT, payroll taxes due to HMRC, any accrued expenses, customer deposits. Also any bank loans that would be due in the next 12 months would be considered as current liabilities.

For example, the company below has current assets of £67k and current liabilities of £46.9k by dividing the current/liquid assets by the current liabilites the quick ratio or acid test comes out at 1.4….

The ideal ratio would be 1.1 meaning you have enough liquidity to clear your current liabilites however, this may vary depending on business sector or industry but as a general rule any lower it reflects your inability to clear your current obligations and higher would place in a positive position.

Even if you’re not looking for investment in your own company it’s always good practice to keep an eye on these ratios, they can fluctuate depending on your business especially if your sales are based on seasonal activity.