Compare current assets (excluding stock) to current liabilities
The acid test ratio measures a fi rm’s ability to raise cash quickly to meet its current liability debts. The value of stock is deducted from current assets because it is considered the most diffi cult current asset to convert rapidly into cash. • To ensure that all bills can be paid as they fall due, a fi rm should have an acid test ratio of at least 1:1.
• If the acid test ratio falls below this level a fi rm may have diffi culty paying its bills and become illiquid.
Acid Test Ratio Formula
Current assets – Closing stock
Current liabilities
| Traction Bikes - Year 1 | Traction Bikes - Year 2 500,000 –
100,000 200,000
= 2 (or 2 : 1)
1,000,000 – 200,000
500,000 = 1.6 (or 1.6 : 1)
Numeracy
In Year 1 Sandra Roche’s calculations show that Traction Bikes had an acid test ratio of 2:1. In Year 2 the acid test ratio declined to 1.6:1. While this ratio is still well above the recommended minimum level, the downward trend should be a concern for Sandra. 1. Based on the income statements and statements of fi nancial position calculate the acid test ratio for Traction Bikes Ltd. in Year 3.
2. What comments would you make to Sandra Roche on the acid test ratio for Traction Bikes Ltd in Year 3?
