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.
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 |
The two main components of a quick ratio are:
Some of the key benefits of using a quick ratio are:
The two main ways to calculate quick ratio are:
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.
Here is how we can interpret a company’s quick ratio:
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.
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.
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