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Absolute Acid Test Ratio

Some accounting experts recommend to calculate absolute liquid or acid test ratio because this ratio will give us correct idea whether our short term financial position is good or not.

Absolute acid means pure acid. Its effect will be very high on marble stone than diluted acid. If marble stone will tolerate the effect of absolute acid, it means that marble is of high quality. We can take the example of Taj Mahal Agra. This Taj Mahal of Agree is tolerating of acid raining from many years but still exists which show the purity and high quality of the marble of Taj Mahal. Like this, company wants to know the capacity of its cash and bank balance for paying its current liabilities. For this purpose, company calculate absolute acid test ratio or absolute liquid ratio. It is just relationship between absolute acid assets and current liabilities.

Formula of Absolute acid test ratio

= Absolute liquid assets / current liabilities

Absolute liquid or acid assets = marketable securities + cash + bank

Main point of analysis

1. If absolute acid test ratio is equal to rule of thumb

Rule of thumb of absolute acid test ratio is 0.5 :1 or 50% of total current liabilities are absolute acid assets. In simple words, if we have 1$ for paying 2$ liabilities it is good because every our creditor will feel good if he will get minimum 50% of cash at any time.

2. If absolute acid test ratio is more than rule of thumb

If absolute acid test ratio is much higher than the rule of thumb, at that time, we analyze our absolute liquid assets. More free cash fund than need will reduce our return on investment. So, we can take some cash fund for investment projects. Upto 1:1 absolute acid test ratio is quit satisfactory.

3. If absolute acid ratio is less than rule of thumb

If absolute acid test ratio is 0.25 which is less than rule of thumb and current and liquid ratio are much more than rule of thumb, at that time, we have to improve cash liquidity by changing the policy of credit sales and advance payments.

Related : Acid Test Ratio

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Accounting Education: Absolute Acid Test Ratio
Absolute Acid Test Ratio
Accounting Education
http://www.svtuition.org/2011/10/absolute-acid-test-ratio.html
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