Quick ratio is a measurement of short-term liquidity or a company’s ability to raise cash for paying bills that are due within the next 90 days. In simple terms, it measures the business’s ability to pay its short-term liabilities. Quick ratio can be calculated by dividing current liabilities by quick assets. The alternative name for this ratio is acid-test ratio and quick liquidity ratio.
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Quick ratio explained
The quick ratio is a measure of a company’s ability to pay off its short-term debts using only its most liquid assets. In simple terms, it helps us understand if a company has enough money in its easily accessible accounts, like cash and short-term investments, to pay its bills right.
Formula for quick ratio is
| Quick Ratio = Quick Assets / Current Liabilities |
What are the components of Quick Ratio?
The two main components of a quick ratio are:
- Quick assets: The total amount of a company’s cash, cash equivalents (such as, money market accounts, savings accounts, certificates of deposits, treasury bills maturing in 90 days, etc), marketable securities (publicly traded stocks, bonds, commercial paper), and receivables. Other current assets such as inventory and prepaids which cannot be turned into cash immediately are not included here.
- Current liabilities: These are mostly obligations that have to be paid within one year. Some of the items include common account payables, like wages, salary, taxes, utilities, interest, and insurance. The current portion of long-term debt to be paid within the next year is also included here.
Advantages of quick ratio
Some of the key benefits of using a quick ratio are:
- Shows a company’s short-term financial health
- Indicates if a company has enough liquid assets to pay off its debts
- Helps assess a company’s ability to handle unexpected expenses
- Can be a warning sign of potential financial trouble
- Helps lenders and investors make informed decisions about lending money or investing in the company.
How to calculate quick ratio
The two main ways to calculate quick ratio are:
- Quick ratio = (Current Assets – Prepaid Expenses – Inventories) / Current Liabilities
- Quick ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
The first formula focuses on the items that cannot be quickly converted to cash. While inventories can be sold for cash, it may take beyond 90 days. In an attempt to sell them off quickly, the company may have to accept a substantial discount to the actual market value. Prepaid expenses may include prepaid insurance and prepaid subscriptions. These items aren’t included while calculating quick ratio since they can’t be used for paying current liabilities.
The second quick ratio formula is similar to the first, however, it concentrates on items that can be turned into cash quickly. Accounts receivable can cause issues in liquidation since some accounts can be delinquent, unpaid or the due dates could be longer than 90 days. However, in most cases, businesses may be able to collect the dues within 90 days unless historical evidence points to the contrary.
Here is an example to better understand quick ratio:
Balance sheet of Company ABC Ltd.
| Assets | Amount |
| Current Assets | |
| Cash on hand | Rs. 25,000 |
| Cash in bank | Rs. 15,000 |
| Short-term investments | Rs. 30,000 |
| Inventory | Rs. 50,000 |
| Accounts receivable | Rs. 75,000 |
| Prepaid insurance | Rs. 5,000 |
| Total Current Assets | Rs. 200,000 |
| Non-Current Assets | |
| Fixed assets | Rs. 80,000 |
| Goodwill | Rs. 20,000 |
| Total Non-Current Assets | Rs. 100,000 |
Quick assets = (Rs. 200,000 – Rs. 50,000 – Rs. 5,000), or Rs. 145,000
Current liabilities are Rs. 160,000
Quick Ratio = Quick Assets / Current Liabilities = Rs. 145,000 / Rs. 160,000 = 0.91
In the above example, Company ABC Ltd has a quick ratio of 0.91. Thus, it has Re. 0.91 of quick assets to pay every rupee of current liabilities.
What is an ideal quick ratio?
Here is how we can interpret a company’s quick ratio:
- Industry specific ratio: Average quick ratios can differ across industries. Industries where cash flows are stable and predictable, like the retail sector, a lower quick ratio is acceptable, as anticipated revenues can be relied upon for supplying required cash. However, in a volatile industry, a higher quick ratio can help in cushioning the business ratio, against revenue shortfalls.
- Risk: Businesses that don’t mind taking on risk can be comfortable with a lower quick ratio whereas a risk-averse management may prefer a much higher ratio.
- Growth: A company that is rapidly growing might prefer a higher quick ratio to pay towards investments and expansion. A steady business may settle for a lower ratio since it may have long-standing business ratio relationships with suppliers and lenders.
- Economic conditions: In situations of economic turmoil, it’s important to improve quick ratios such that the business can handle unforeseen shocks.
- Inventories: Some companies may have inventory types that are very easy to liquidate without a major discount. In such cases, the current ratio (current assets/current liabilities) could be a better indicator of liquidity since it includes prepaid expenses and inventories under assets, whereas a quick ratio does not.
- Accounts receivable: If a company finds it difficult to collect its accounts receivables, it is better to raise the quick ratio by setting aside additional cash. Companies that have a short and predictable accounts receivable cycle can manage with a lower quick ratio.
- A high quick ratio: A very high quick ratio means that some of business money is not being put to use. This can signal inefficiency and can cost the company its profits. If there is no special need for a high quick ratio, it is better to bring it down to an industry average.
Conclusion
If a business’s quick ratio is under 1, it indicates a lack of sufficient quick assets to cater to all its short-term obligations. If the business suffers in certain economic situations, it may not be able to raise the required cash to pay its creditors. Additionally, the business may have to pay high interest rates while borrowing money. Therefore, a business must aim for a quick ratio at close to 1 to showcase availability of sufficient assets which can be used to pay off liabilities.
FAQs
Quick ratio cannot be used as the sole indicator of a company’s liquidity. Since it does not consider any time periods, the accounts receivables may turn into bad debt and affect the company’s liquidity.
Quick ratio analyses a company’s ability or inability to discharge its debt obligations using its available liquid assets.
Acid-test ratio is an alternative name for quick ratio. It measures a company’s ability to pay short-term liabilities using liquid assets.
To improve the quick ratio, a company can increase its sales and inventory turnover, work on its invoice collection period and pay off liabilities at the earliest.
If the current ratio is too high it shows that the company is inefficiently using its current or liquid assets and may be sitting on too much cash.
