What Is Retail's "Acid Test Ratio"?
How healthy is your company?
One of the factors banks consider when reviewing an application for a small business loan or line of credit is an acid test ratio. This is a measurement of how well your business can meet its short-term financial obligations without selling any inventory. In other words, how healthy is your retail business if sales suddenly stopped? That may sound like an extreme example, but what if major street repairs limit access to your business for a few months? What if your store is hit with a heavy storm and you have to close for repairs for a few days?
This test also is known as the quick ratio or liquid ratio, but these are just different labels for the same calculation based on which industry is using the term. The calculation shows how easily a company could be liquidated and helps financial institutions decide how creditworthy the company is. The easier it is to liquidate, the less risk the bank or financial institution is taking on when offering you a loan. The term "acid" comes from the practice of using acid to test precious metals. Miners used to put acid on gold to see if it was real. If it was authentic gold, it would stand up to the acid; if it was not, it would turn green.
A Simple Calculation
Calculate your ratio with this formula: Liquid Assets ÷ Total Current Liabilities
So, if you have $20,000 cash in the bank and $10,000 in accounts receivables, your liquid assets are $30,000. (Inventory or physical assets like tables and chairs are not included in this equation.) If your current liabilities (debts) are $20,000, then your ratio is 1.5:1.
A ratio greater than 1:1 is good and indicates the business can pay its current liabilities without being dependent on the sale of inventory. Financial institutions and investors want this ratio as high as it can be to ease the risk of investing in you and your retail store. You may have a family member who has invested in the business who wants to know how well his investment is doing. In most cases, he will ask for your profit and loss statement (P&L) and balance sheet. However, those reports are a snapshot in time and do not illustrate how well you could survive a bad period.
Use the Information
Some retail businesses run this test to determine markdowns. A business in a poor or unhealthy position with its acid test ratio might create a huge sales event to generate cash flow and lower inventory levels.
Cash flow is vital to running your business from day to day, but an acid test ratio will help analyze long-term health or sustainability. Many retailers operate at a ratio below 1:1 and struggle to get money when they need it. Before going to your bank, run this test for yourself. If you share this information with them when applying, you ease their concerns about risk while also demonstrating that you are a savvy business professional. And that is what every bank or investor wants at the helm of the business.