Acid Test Ratio for Retailers

If you are a heavy investor, you may have heard the term Acid Test Ratio. Or perhaps you heard the term from your accountant or bookkeeper. As a retailer, your bank will look at this calculation whenever you apply for a line of credit or business loan. 

The acid test ratio 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.

Now that may sound like a "wild" example, but consider the city deciding to redo the street in front of you store and essentially blocking access for a few months. Or what if your store was hit with a heavy storm and you had to close for repairs for a few days?

The purpose of this calculation is to show how easily a company could be liquidated, and therefore help financial institutions decide upon how credit worthy the company is. The easier it is to liquidate, the less risk the bank or financial institution is taking on when offering a you loan. The name "Acid" comes from the practice of using acid to test precious metals. Miners use to put acid on gold to see if it was real. If it was authentic gold, then it would stand up to the acid; if it was not, it would tun the gold green. 

To calculate this ration, Current Assets - Inventories ÷ Total Current Liabilities. So, if you have $20,000 cash in the bank and $10,000 in accounts receivables then your current assets are $30,000 (since we do not include inventory or physical assets like table and chairs.) 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 banks and investors, want this ratio as high as they can to ease the risk of investing in you and your retail store. You may have a family member who has invested in the business and they want to know how well his investment is doing.

In most cases, he will ask for your P&L (profit and loss statement) and balance sheet. However, those reports are a snapshot in time and do not illustrate how well you could survive a bad period. 

We used to run this test on my retail business to determine markdowns. If we were in a poor or unhealthy position with our acid test ratio and our inventory turns have been too low, we would create a huge sales event to generate cash flow and lower our inventory levels. (Remember, low inventory turns means cash sitting in your backroom instead of paying your bills.) 

This test is also known as Quick Ratio or Liquid Ratio. These are just different labels for the same calculation. This variations of names occur based on the industry using the term. Ultimately, cash flow is the key to running your business from day to day. But and acid test ration will help analyze the long term health or sustainability. Many retailers operate at a ration below 1:1 and therefore struggle to get money when they need it. Before going to your banker, run this test for yourself. If you share this info with them when applying, you not only ease their concerns on risk, but you demonstrate that you are a savvy business professional as well.

And that is what every bank or investor wants at the helm of the business.