Here’s how the acid test is performed. Add up cash and accounts receivable. Then, divide that total by the accounts payable. For example if cash and accounts receivable are $100,000, and accounts payable are $80,000, then the “acid test” ratio is 1.25 ($100,000 divided by $80,000 is 1.25).
Suppose cash and accounts receivable are $80,000, and the accounts payable are $100,000. Then the ratio is .80 ($80,000 divided by $100,000 = 80).
The positive ratio means that the business has $1.25 on hand for every $1.00 of accounts payable.
The negative ratio means that the business has only $.80 on hand for every $1.00 of accounts payable.
Here’s another “acid test” ratio for you, maybe even more important than the first “acid test.” Suppose you won $10,000,000 in the lottery. Would you continue to run your business because you love what you’re doing so much, because it’s your life’s work, it’s what gets you up every day? Or would you retire to a warm, sunny beach and sip pina coladas all day?
If you would chuck it all and retire, maybe it’s time to re-think what you’re doing?!