Understanding the Financial statements – Acid Test ratio and ROA ratio

What is the acid test ratio and ROA ratio?

Investors calculate the acid test rate, also known as the quick ratio or the pounce ratio. This ratio excludes inventory and prepaid expenses that are included in the current ratio, and limits the amount of assets that can be converted into cash and business to cash. This limited asset category is known as quick or liquid assets. The acid-text ratio is calculated by dividing the liquid assets by their total current liabilities.

This ratio is called the business ratio to emphasize that you are in the worst case scenario. Short-term creditors are not entitled to request immediate repayment, except in exceptional circumstances. This ratio is a conservative way of looking at the ability of a business to pay off its short-term liabilities.

One of the factors that impact a business’s bottom line is profitability. A business can realize a financial advantage, which means that it makes more money from borrowed money than the interest it pays to use the borrowed money. Financial stimulus may be a good part of a business’s net income for the year. The ROA ratio is determined by dividing earnings before interest and income tax by net operating assets.

An investor compares the ROA with the interest rate the corporation borrowed. If the ROA of a business is 14 percent and the interest rate on debt is 8 percent, the net profit on the capital of the business is 6 percent higher than the interest paid.

ROA is a useful ratio for interpreting profit performance other than determining financial profit or loss. ROA is a capital utility test that measures the profit before interest and income taxes on the total capital employed by the business.