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What's the purpose of the acid test? Should it be redefined?

The company where I work is involved in construction. Our financial statements are reviewed by outsiders more so than other privately owned companies. Ratios that are seem useless are used, picking apart the company's financial position to see if our bonding capital should be increased, how likely we are to finish a job on time, pay vendors, turn A/R into cash, etc. Then there's the acid test. The acid test ratio, which is also called the quick ratio, is the similar to the current ratio with the exception that the acid test ratio doesn't include inventory in its calculation. The acid test includes short-term investments, but should it? If a company has a just-in-time inventory method where they are keeping a small amount of inventory on hand each month there is a greater chance that the company’s inventory would be more liquid than its short-term investments. After all, short-term investments are investments that will expire within one year. Maybe the reason why short-term investments are included is because they are made up of stocks and bonds that can sold quickly. However, should we, as financial professionals, when considering the acid test, only take into consideration unrestricted cash, accounts receivable, and current liabilities? If part of the test is to ignore inventory should we not also ignore short-term investments? What are your thoughts?

Answers

Topic Expert
Christie Jahn
Title: CFO
Company: Prime Investments & Development
(CFO, Prime Investments & Development) |

I think it's about measuring whether your short term assets can pay off your short term debt without having to worry about trying to sell off inventory. While it's easy to say inventory can be sold quickly that may not be reality. If you are holding a unique style of flooring for example it would take a unique type of buyer to get rid of it and would they will be willing to pay what you have into it? If you are holding 2x4's yes chances are you can rid yourself of those quite easily, however the acid test isn't measuring what you think you can sell. If you want to include inventory because you know your inventory can be moved quickly use working capital ratio.

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