How is the acid-test ratio calculated?

The acid-test ratio, also known as the quick ratio, is a key financial metric used to assess a company's liquidity and ability to meet short-term obligations. This ratio specifically measures the proportion of the most liquid assets (excluding inventory) to current liabilities.

The correct formula for calculating the acid-test ratio is derived from the need to evaluate a company's short-term financial health without relying on inventory, which may not be as readily convertible to cash as other assets. By deducting inventory from current assets, the formula focuses on cash, cash equivalents, and receivables. This gives a clearer picture of how well the company can cover its current liabilities with its most liquid resources.

Thus, the acid-test ratio is calculated as:

(Current assets - inventory) / Current liabilities

This calculation illustrates how many dollars of liquid assets are available for every dollar of current liabilities, providing vital insights into a company's short-term financial stability. It is particularly useful for stakeholders, such as investors and creditors, to understand if the business can effectively manage its financial responsibilities without depending on the sale of inventory.