What is the Acid Test Ratio and the ROA Ratio? Why Are They Important Investment Ratios?

Having a degree in business administration with a concentration in accounting, I figured I could write a few articles about investing. There are certain ratios you should use to help determine whether a stock is a smart buy or not. This article is about what is commonly referred to as the acid test ratio. It can also be called the quick ratio, or the pounce ratio. This article will also cover another ratio, known as the ROA ratio.

The acid test ratio is important because it helps to show how healthy a company it is; in terms of being able to pay off any short-term debt is that it may have acquired. Basically, the premise of this ratio was to use as a test for a doom and gloom scenario for a company. For example, say all of the company's or institutions, creditors would suddenly demand payment for outstanding debt; this ratio would allow you to see how easily the company could pay off the demanded debts. However, it should be noted that short-term creditors can only demand payment immediately under extreme and rare circumstances.

This ratio differs from the current ratio because it does not factor inventory and pre-paid expenses into the calculation. This ratio includes cash the company has on hand and highly liquid assets, the company can dissolve quickly. In other words, highly liquid assets are those which can be quickly turned to cash if the need would arise. The acid test ratio is actually quite simple to calculate. You divide liquid assets by all the current liabilities the company has accrued.

In other sign of financial health for a company is if it is leveraging its debt in a profitable manner. This sounds a little strange, but it is not a difficult concept to understand. Companies regularly borrow money; what the company does with that borrowed money will determine whether the company will pass or fail the ROA ratio.

Basically, as long as the company is earning more profit on the borrowed money than what it does in interest rates, it will have a good ROA ratio. In fact, a large portion of a company's year end net income can be derived from leveraged debt. To calculate the ROA ratio you divide earnings before interest and income tax, otherwise known as EBIT, by net operating assets. To give an example, if a company's ROA is 20% but the interest rate on the money borrowed is 6%, the company has a capital net gain of 14%. This is good for the company and its investors. Conversely, if the interest owed is higher than the company's ROA, this is bad news for the company and its investors.

ROA ratio has two uses. It helps you see if the company had financial gain or loss. It also allows the potential investor to see the profit, excluding interest and income tax earned on all the capital leveraged by the company. By using these two ratios, you will be able to get a better idea of whether the stock is a good buy or not. However, you should always do further research into a company before investing based on a few ratios you calculated.