If you’re going to borrow money or have plans to expand into a new market, you probably need to know how much money you have. There are different ways to do this, but one of the most useful is to work out your acid test ratio.
An acid test ratio, sometimes called a quick ratio, is a measure of your company’s liquidity. Done right, it gives a clue to how much cash you have on hand and how much you can raise in a hurry. The ratio is determined by adding all your company’s cash, securities, and money you’re owed (“receivables”), and then dividing that figure by whatever you owe to others. The resulting ratio is your liquidity.
For example, if your consulting business has R1,000 in cash on hand, R50,000 in the bank, and you’re owed R9,000, your liquid assets are R60,000. If you use your car to drive to clients’ offices but still owe R20,000 on the loan (and that’s all you owe), your quick ratio is 3:1.
This may sound a lot like a current ratio, which is also used to work out your company’s liquidity, but it’s a little more narrowly focused than that. A current ratio includes factors like real estate your company owns and whatever tax benefits you expect to take next year. It deals, in other words, with an exhaustive list of the assets you have and the assets you expect to have soon. The acid test only touches on stuff you can either spend right away or assets you can liquidate really quickly, like bearer bonds.
In many ways, the acid test ratio is a more accurate tool than the current ratio, if only because it deals with assets in your hands right now. Using it to work out your firm’s liquidity gives a fairly useful benchmark for how much money you really have, which is helpful for taking out a loan or making other major financial decisions.
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