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Every Entrepreneur Should Do Acid
Let’s face it – we entrepreneurs are all pretty optimistic people. I mean, we come up with these business ideas and we’re willing to tweak them until we can get them to work. Fortunately for the optimist there is a reality check that can be used to maintain a comfortable level between it’s a sure thing and that will never fly. It’s called an acid test, and most banks and seasoned investors will want to see one.
The Acid Test, also known as the Quick Ratio, is derived from the Current Ratio. Thus, we need to briefly discuss the Current Ratio first. Anyone that is currently running a business or is in the planning or startup phase will want to be concerned with managing the cash flows of the business.
The Current Ratio does just that. It is simply the ratio of the firm’s current assets divided by the current liabilities. The current assets are those that are the most liquid – namely cash, accounts receivable, and any inventory. Current liabilities are those bills that are due within this year (the current term). If your firm’s current liabilities begin to exceed the current assets, you run the risk of a cash shortage and could soon be facing liquidation just to meet your current obligations. You don’t want to be forced to go deeper into debt just to pay your monthly bills as this only makes it harder for your business to continue to survive.
If you take the inventory out of the Current Ratio you are now left with the Acid Test. This is basically a method used to determine the liquidity of the business, namely how much cash is on hand to pay the monthly bills. The acid test is also an excellent gauge when used along side the Burn Rate, which is simply the amount of money being spent in a given period during the startup phase of the business (or a period of less income than expenses – this could be an off season, such as a homebuilder in Minnesota during the winter).
If you know you’re burning through $3,000 per month and expect break even to be reached during the 7th month of operations, you know you need $18,000 to carry you over till you start to break even and turn an operating profit (6 months times $3,000).
If your Acid Test ratio is less than 1.00 you know your cash is less than your current debt and you are going to face a cash crisis soon unless you can turn things around. The Acid Test could be less than 1.00 because sales were not as high as expected (thus not as much cash in hand and you are holding more inventory – which as you know we do not include inventory in the Acid Test) or it could be that your business is taking on too much debt given the amount of money it’s bringing in (e.g. you owe $10,000 each month and only bring in $1,000 in sales). We don’t include the inventory in the Acid Test because, well to be quite frank, you’ve obviously not sold it yet and if your company is struggling it could be that no one wants the product! When a company has to be liquidated, it seems inventory is always sold pennies on the dollar. This is the reality check part of the Acid Test.
An Acid Test of 1.00 means your cash and debt levels are equal. Please don’t think that equal means optimal!!! The higher the ratio the better. What if sales dropped off and you start burning through more cash?! The ratio would quickly slip below 1.00.
One final note about Acid Tests, Current Ratios, and Burn Rates: these numbers are only representative of what is going on in the business today. I would be much less concerned about a startup with an Acid Test ratio of 0.80 that just landed a huge contract with a Fortune 500 company than another entity that has an Acid Test ratio of 1.20 and is in the business of making typewriters, payphones, or door-to-door sales of encyclopedias. I’m sure you all understand why that is. If your business and its industry has a bright future, it’s understandable that you are taking on additional debt now to get your operations up and running.
To sum it up: if you have an Acid Test ratio less than 1.00 your Burn Rate will be accelerating and you will see a more rapid depletion of cash in your business in the near future. An Acid Test ratio greater than 1.00 will generally indicate more cash coming into your business (this could be from increasing sales and/or a reduction of current liabilities) and is a rough indication of growth or growth potential.
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