The Quick ratio is a Financial Ratio that is calculated to measure a company’s short-term liquidity.
Its computation is similar to that of the current ratio, only that inventories and prepayments are excluded.
This makes the ratio a more conservative measure of company liquidity.
The ratio derives its name from the fact that assets such as cash and marketable securities are quick sources of cash.
The quick ratio is also referred to as the acid-test ratio.
The name acid test ratio is in reference to the historical use of acid to test metals for gold by early miners.
If the metal passed the acid test, it was considered gold.
If the metal failed the acid test by corroding from the acid, it was a base metal and of no value.
The acid test ratio in accounting and finance shows how well a company can quickly convert its assets into cash in order to pay off its current liabilities.
The Quick Ratio Formula
The Formula for Quick Ratio is
Quick ratio = (Current assets – Inventories) / Current Liabilities
Quick Ratio = (Cash and Cash equivalents + Marketable Securities + Accounts Receivable) / Current liabilities.
where Marketable securities are those securities (investments) which can be easily converted to cash within a short period of time at a negligible decrease in value. Examples include government treasury bills, shares listed on a stock exchange, etc.
The Quick Ratio is expresses as a "number" instead of a percentage.
The "number" measures the amount of liquid assets available for the corresponding amount of current liabilities.
For Example, a quick ratio of 1.5 would mean that a company has $1.50 of liquid assets available to cover each $1 of current liabilities.
Similarly, a Quick Ratio of 3 would means that the company has $3 of liquid assets to cover each dollar of current liabilities and so on.
In a nutshell, the higher the ratio, the more financially secure a company is in the short term.
As a rule of thumb, if an immediate need arises - companies with a Quick Ratio of over one should be able to pay their Current Liabilities.
Seasonal variations in some industries may cause the ratio to be higher or lower at certain times of the year as seasonal businesses experience irregular bursts of activities leading to varying levels current assets and liabilities over time.
Why are Inventories and Prepaid expenses not included in the calculation?
Inventories generally take time to be converted into cash, and if they have to be sold quickly, the company may have to accept a lower price than cost for these inventories, thereby undergoing a loss.
Since most companies would be very hesitant to sell their Inventory at a loss, lenders prefer using the Quick Ratio which excludes Inventory to measure company liquidity.
As far as Pre paid expenses are concerned - these are future expenses that have been paid by a company in advance such as Rent, Health Insurance etc.
If the company has an urgent cash requirement, these expenses will do nothing to add to the short term cash need of the company and are therefore justifiably excluded from calculation of the Quick Ratio.
If a company has cash + marketable securities + accounts receivable with a total of $1,000,000 and the company's total amount of current liabilities is $1,500,000, its quick ratio is 0.66 ($1,000,000 divided by $1,500,000 = 0.66)
Review the Current Assets and Current Liabilities of Superpower Inc. below.
Current Portion of Long Term Debt
Using the Formula with the information above, we can calculate Superpower Inc's Quick ratio as follows:
($70,000 + $20,000 + $40,000) / $75,000 = 1.73
This means that for every dollar of Company XYZ's current liabilities, the firm has $1.73 of very liquid assets to cover those immediate obligations.
In the example above, the quick ratio of $1.73 shows that Superpower Inc has enough current assets to cover its current liabilities.
However, be aware that some Industries have a typically long receivables recovery duration (such as in the construction sector)
In such cases, it may also be appropriate to calculate the quick ratio by excluding receivables from the numerator to give a more suitable evaluation of the company's short term liquidity.
Like most other measures, the quick ratio does have some potential drawbacks.
To begin, the Quick Ratio provides no information about the level and timing of cash flows, which are extremely important in determining a company's ability to pay liabilities when due.
The quick ratio also assumes that accounts receivables can be made readily available for collection when needed, which is not the case for many companies.
Finally, the formula assumes that in case of immediate need, a company would liquidate its current assets to pay current liabilities, which is not realistic, considering some level of working capital is always needed to maintain operations.
For best use, the Quick Ratio should never be looked at in a vacuum, as a standalone ratio.
It should always be compared with the past and other companies in the same Industry.
When used in conjunction with other Ratios and Financial Metrics, the Quick Ratio becomes an invaluable tool to measure the health of a company.
For a deeper insight into Ratios, check out our Full article on Ratio Analysis.
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