Introduction
Acid tests are crucial tools for any business to use, and there are many benefits for business owners to use an acid test. Configuring debt, and especially knowing if a business can pay off their short-term debts will help a business run more efficiently. It is also a good way to see if there are any issues with money, and the simple test can provide a simple answer. One of the best things about acid tests is that any business can use it. It works for retail, IT, and any business model. Here are some things a business owner should know about acid tests. Also, check Acid Test on our glossary.
Removes Inventory
Figuring out liquidity can be difficult, especially when you’re dealing with inventory. The acid test will remove your inventory from your calculations, which provides you with a more accurate picture of the liquidity of the company. This action can help when a business is looking to pay off their short-term debts and to find out if they can do it without going bankrupt. A good example of this is when a retailer has a lot of inventory in stock. They can remove the inventory to see if they can pay off the debts with what they have.
Removes Current Liabilities
Bank overdrafts and cash credit can be current liabilities that can hinder any business looking to pay off their debt. It goes hand in hand with your inventory, and since inventory is discounted from the acid test, you don’t need to include the overdrafts and cash credit. The ratio takes a more accurate approach to finding out the exact liquidity of the business. Without those external factors, you will have a more accurate picture of what your business is doing, and where it is going.
No Marketable Values Included
Inventory prices can rise and fall, due to the market demand, which happens daily. Taking those equations out of the picture solidifies your position with the inventory you do have. Those market prices won’t handcuff the acid test ratio on your inventory, which paints a clearer picture of your company. This way, you can determine whether you can pay off your short-term debt, without guessing. After all, you’re trying to keep your business running, and eventually grow. It can be difficult to do if you don’t know how the market is going to react.
Avoid Seasonal Inventory
In retail, many products are set out for the season, and the leftovers are sold for a lower price, or just abandoned altogether. When that seasonal inventory is included with your finances, it can inflate or deflate your true liquidity value of the company. Excluding the inventory from the acid test allows your company to have a true idea of what your company stands. You will have an honest answer about the true liquidity of your company, even if you’re still stuck with merchandise from Halloween.
Reliable Repayments
Where dying industries occur, inventory will be included, which can make repayment impossible for some companies and businesses. Using the acid test will help a business determine a more reliable way to make payments. Some businesses and companies use the current ratio to configure a repayment method, and this formula includes the inventory. This can make payments higher than the company can afford, which means paying off a debt for a long time. Using the acid test will ensure you can make payments in a realistic manner, and prevent the business from going bankrupt.
Realistic Numbers
When using the current ratio, where inventory is included, your numbers can inflate your short-term financial strength. Many companies make the mistake of applying for a new loan because their finances look good because of their inventory. The acid test keeps the numbers at a realistic place. This indicator will help when a business goes to apply for a new loan. Since inventory can inflate and deflate quickly on the market, that new loan may be too expensive to pay back right away. Having a realistic sense of where your numbers are, it will help you determine the right financial track for your business.
Conclusion
Using an acid test for your business will prevent any financial pitfalls you may face. While the current ratio is good for knowing what your business is worth, the acid test will give you a more accurate sense. Some companies prefer to use the current ratio test, and those numbers can drastically affect a company, especially when it comes to making short-term payments. Though the current ratio test will help a company decide what inventory is on the rise on the market, an acid test will help you decide whether you can pay your short-term debts. This is a crucial test that will give a business insight into how much they can borrow, and if they can meet the payment demands.
