The Acid Test – Can You Make It?

The Acid Test is a ratio used in business to measure how liquid your business is. It allows you to keep track of the financial pulse of the practice.

A ratio is just a comparison of several pieces of information that, when compared, tell you more than the single piece of information would.

The Acid Test allows you to quickly assess whether or not cash flow will be a problem if, for example, your revenues should slow or suddenly drop significantly.

Here’s the formula:

Cash                          (cash in the till, money in checking and savings, money market)
Current Liabilities      (accounts payable, taxes due, current amount due on loans)

Since we are looking at a specific point in time with this test, your liabilities are for that specific period. Let’s use one month as the example. So to get your current liabilities, add up all the bills that are due for the month along with any payments that are due on notes or loans or any tax payments that are due. This figure is your current liabilities.

Divide your cash by your current liabilities. The number you get is the ratio.

With the Acid Test, the ratio should be close to 1.

Numbers under “1” mean that you may run short of cash. Numbers very much over “1” mean that there is extra cash.

Depending on how much extra cash there is, and what your upcoming cash needs are (those that will occur just past the time period you measured, like the following month), it could be that you should be seeking ways to invest or maximize this cash, doing something more productive than just having it “sit”.