The current ratio and the Acid-test ratio, both fall under the category of financial ratios. These two ratios examine the capability of an organization to pay those creditors, whose debts are below the stipulated period of twelve months. Such short-term debts usually consist of 30 or 60 days credit period. Indeed under the two ratios the Current Liabilities are considered as the debt to be covered by the assets considered on the numerator of the ratio.
The higher these ratios, the better are the financial position of the firm. However, a number of factors have to be considered by both ratios before remarking on the financial position of the company. For instance, one has to consider the nature of the business and the effect of seasonal variations before giving drastic conclusions. In fact, such ratios are frequently examined by analyzing the financial position of the same organization over time or in relation to the industry average in which the firm operates.
The main difference that lies between these ratios is the analyses of the liquidity of the current assets taken. Under the current ratio, all the current assets of the firm are considered in the formula. However, the acid-test ratio examines the assets that can be easily converted into cash in relation to the current liabilities of the firm. As a result, the stock value, which is the least liquid asset, is deducted from the current assets in this ratio.
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Under these ratios, the short-term assets are divided by the current liabilities in order to see by how many times can such assets cover these liabilities. For instance, if at the financial year ended 31st December 2006 a firm had a total current assets of $200,000, and the current liabilities added up to $100,000, the current ratio would be calculated as follows:
This result indicates that the current assets of the firm can meet by two times as much the present current obligations of the organization. The same principle applies for the acid-test ratio with the exception that stock is removed from the current assets as already stated in the previous paragraph.
