One of the factors banks consider when reviewing an application for a small business loan or line of credit is the acid test ratio. This ratio is a measurement of how well your business can meet its short-term financial obligations without selling any inventory.
The acid test ratio illustrates how well your business can handle a sudden drop in sales. This may sound extreme—but this is exactly what happened to many retailers in March of 2020 when states issued emergency stay at home orders.
The acid test will tell you if your business is able to manage in situations where revenues suddenly plummet; it might even indicate how long your business can last if the situation is extended.
What Is the Acid Test Ratio?
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.
It is now used in the financial, investment, and retail industries to refer to how quickly a company can be liquidated. This helps financial institutions decide how creditworthy the company is while helping a retailer determine whether a debt or financial crisis can be dealt with.
The easier it is to liquidate, the less risk the bank or financial institution is taking on when offering a business a loan, and the more able to handle short-term financial woes a retailer is.
How Do You Calculate the Acid Test Ratio?
The information needed to figure out the ratio is taken from a business' balance sheet. Not all businesses use the same accounting methods and definitions—if you don't have a balance sheet, you should be able to find your total current liabilities by subtracting any long-term debt (greater than a year) from your total debt, giving you the amount you owe within a year's time.
Liquid assets might be a bit trickier—if they are not already calculated on your balance sheet, you can estimate them by adding up any assets that can be converted to cash fairly quickly (except inventory), such as money market equivalents, securities that can be sold quickly, accounts receivable, or business savings.
Calculate the ratio with this formula:
Once you have the result, you use it to judge your business' ability to liquidate to pay off short-term debts.
How the Acid Test Ratio Works
Assume you have $20,000 cash in the bank and $10,000 in accounts receivables—you have liquid assets worth $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—you can also read this as $1.50 of liquidity to every $1.00 of short-term debt.
A ratio greater than 1:1 is generally viewed as good and indicates that the business can pay its current liabilities without being dependent on the sale of inventory—this is why inventory is excluded. Financial institutions and investors like to see this ratio as high as it can be to minimize any risk of investing in your retail store.
Some retail businesses run this test to determine markdowns. A retail business with a low acid-test ratio might create a sales event known as a liquidation sale to generate cash and lower their inventory levels.
While a high acid test ratio is a great indication for your business, if it is too high, you might want to consider putting some of that cash or liquidity to use to further invest in your business.
In the case of a crisis, you can use the acid test as a gauge of how long you can operate. You'll need to make a sequenced liquidation plan to last as long as you believe the crises will last—which is a plan to liquidate at regular intervals, such as monthly. You then run the acid test against the planned liquidation to see if the event will sustain you for the next month or period.
Limitations of the Acid Test Ratio
The acid test is a test of current liquidity to debt—as such, it is not much use for investors unless they want to know how the business would cope with a sudden drop in sales or business.
Since acid test ratios indicate that a business has enough liquidity to cover short-term debts, and lenders like to see high ratios, you might consider saving as much as you can to keep raising your ratio. This might not be the best course of action, however. If you have built a high amount of liquid assets, you might consider putting some of them to work for you in the form of investing, research, or expansion.
This way, you keep enough liquid assets to reasonably cover your short-term debts and then use the rest to grow your business.
- The acid test ratio is an indicator of a retailer's survivability in case of a short-term revenue drop, by comparing liquid assets to current liabilities.
- A ratio of 1:1 means there is $1 of liquid asset to $1 of current liability.
- Retailers should strive for ratios of greater than 1:1.
- The acid test is a good indicator for retailers who want to judge their short-term survivability.
- Too high of a ratio indicates you might be able to put some liquid assets to better use or incorporate them into a crisis management strategy.