All about the immediate liquidity ratio

The immediate liquidity ratio is the total amount of a company's quick assets divided by the sum of its net liabilities and its reinsurance liabilities.. Fast assets include all liquid assets such as cash, short-term investments, equities, and corporate and government bonds that are approaching maturity.

Calculating this ratio provides insight into the amount of liquid assets that a company could tap in a short time, should liquidity be needed.

What is the acid liquidity test?

The immediate liquidity ratio is also known as the acid test. This index measures a company's ability to meet its obligations in the present, hence its name “immediate”:

The short term is associated with this measure, which can be interpreted in two different ways:

• Measuring the level of the most liquid current assets available in a ratio in the denominator of which current liabilities are placed. Its calculation provides an insight into the company's ability to meet its current obligations.
• Excluding inventory and other current assets, which are generally more difficult to convert into cash quickly. A higher quick ratio means a more liquid current position.

What is the acid test for calculating the immediate liquidity ratio?

The formula for calculating a company's immediate liquidity ratio is as follows:

Current assets (net of inventory and non-inventory) divided by current liabilities

However, The formula for the immediate liquidity ratio itself already makes it clear that it is not an indicator that should be overly relied upon. In fact, if inventory is not removed from the equation, it is not a perfect indicator. By not discounting inventory, the ratio is posited as better than the firm's actual ability to meet its short-term obligations.

The acid test assumes that a company will liquidate all current assets that comprise the quick ratio to cover short term debts, which is something that the company will do in the short term. unrealistic as the company still needs a level of working capital to be able to continue as a going concern.

What does the immediate liquidity ratio tell us?

The immediate liquidity ratio is an important measure of a company's ability to cover its liabilities with relatively liquid assets.. A company with a low quick liquidity ratio that encounters a sudden increase in liabilities may have to sell long-term assets or borrow money to cover its obligations.

It should be borne in mind that, when calculating this ratio, the result obtained should be expressed as a percentage. Depending on the type of company and its obligations, ratios higher than 20 or 30 % may be considered as good, although it should be borne in mind that, in all cases, For safety reasons, this calculation should be complemented by the liquidity ratio and the solvency ratio, which really give a more complete picture of the company and its financial health..