What is the ATR Ratio?
Historically investors have used the Acid Test Ratio (ATR) as a method of assessing how quickly a company’s assets can be turned into cash. The Acid Test Ratio is therefore a test of liquidity.
Defining the ATR Ratio
This important measure of a company’s liquidity is calculated as:
Acid Test Ratio (ATR) = (Current Assets – Inventory) / (Current Liabilities))
Industry investors quote the ATR ratio as a number and not as a percentage.
What Does the Acid Test Ratio (ATR) Ratio Imply to the Investor?
Investors will look at the relative size of the Acid Test Ratio compared with other organizations. This is often viewed as an important indicator of a company’s financial strength and its ability to meet short-term obligations. It excludes inventory since inventory is often viewed as difficult to sell quickly at a reasonable value. A higher numerical number would indicate a better liquidity, when compared with another company; however detailed analysis is always needed. Investors are often quoted as saying they believe the ratio should be at least 1.0.
Why Acid Test Ratio (ATR) is Considered an Important Measure of Liquidity to the Investor
Many investors consider ATR the primary measure of profitability since it compares the inputs (total capital invested into the company) with the outputs (profits generated by the company).
Why Acid Test Ratio (ATR) Considered an Important Measure of Liquidity to the Supplier
The ATR gives a potential supplier an indication of the organization’s ability to pay. It is therefore standard practice for potential suppliers to quickly calculate this simple liquidity measure. Ongoing suppliers would also find this assessment useful on a regular basis. It is worth noting that the Acid Test Ratio helps assess the potential situation in a bad situation, where the suppliers (creditors) were putting significant pressure on the company to pay (without allowing them the time or opportunity to realize the value of the inventory).
Alternative Definition of the Acid Test Ratio
This important liquidity ratio can also be defined as:
Acid Test Ratio (ATR) = (Cash + Accounts Receivable + Short-Term Investments – Inventory) / (Current Liabilities))
What are the Key Problems with Acid Test Ratio Analysis of a Company (or an Industry)?
The following are sometimes quoted as potential problems with the Acid Test Ratio (ATR):
- Many investors often quote a requirement of 1 for the ATR; however this expectation will vary by industry and company, depending on the specific risks.
- It needs to be considered in context. For example comparing the Acid Test Ratio values over a period of time, or by comparing the ATR with the Working Capital Ratio.
- This ratio uses balance sheet values and is therefore only a snapshot. It simply provides a picture of the situation at the close of play on one specific day.