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What’s it: The quick ratio is a financial ratio to measure liquidity by excluding some less liquid accounts such as inventory. It tells us how much more liquid current assets can cover short-term liabilities. Inventories and some other less liquid accounts were excluded because they were deemed unable to be immediately converted into cash. We also call this ratio the acid-test ratio.
The quick ratio is stricter than the current ratio because it excludes less liquid accounts such as inventory. However, interpreting both is the same, where the higher the ratio, the better. A higher ratio indicates the company has sufficient current assets to pay short-term bills.
Why is the quick ratio important?
The quick ratio measures the company’s financial liquidity. It gives us an insight into a company’s capacity to pay its short-term liabilities without selling its inventory or taking on short-term debt.
Companies can use cash and cash equivalents to pay bills. Or, the company withdraws its short-term investment and uses the money to pay off short-term obligations. Another alternative is to collect payment from the customer.
We then add up the figures from these sources and compare them to current liabilities. If it exceeds current liabilities, it is less likely to experience liquidity problems. In other words, the company should easily cover its current liabilities.
This ratio is often used in conjunction with the current and cash ratios to examine liquidity. And then, along with the solvency ratios, it is important to evaluate the company’s financial health. And, if the quick ratio is only concerned with short-term liabilities, the solvency ratio also pays attention to long-term liabilities, not only short-term.
How is the quick ratio different from the current ratio?
The quick ratio is stricter than the current ratio in evaluating a company’s liquidity. Even though both use the same denominator, both use different numerators to evaluate.
The quick ratio only takes more liquid assets into the numerator, including cash and cash equivalents, marketable securities, and accounts receivable. As a result, companies can quickly and easily convert them into cash to pay short-term bills.
The ratio excludes less liquid assets such as inventory. Converting inventory to cash takes a long time, much longer than converting accounts receivable. First, the company has to sell it, and if it is sold on credit, it doesn’t immediately generate cash inflows. Then, the next task is to collect payment from customers to get cash.
Then, we also exclude other current assets, such as prepaid expenses. It arises when a company has paid a supplier for future delivery of goods or services. It includes current assets because they flow future economic benefits, although not cash inflows. Thus, it cannot be converted into cash.
Back again to the difference between quick ratio and current ratio. The current ratio takes these less liquid accounts (prepaid inventories and expenses) into the calculation. On the other hand, the quick ratio does not. Thus, the current ratio can be less representative of the company’s actual liquidity conditions than the quick ratio.
How to calculate a quick ratio?
Calculating quick ratios is relatively easy because the inputs are readily available on the balance sheet and require only arithmetic operations. Usually, there are two approaches to calculating a quick ratio, mainly with regard to the numerator used.
First, some people simply add up the cash and cash equivalents, short-term investments, and accounts receivable. Second, others calculate this ratio by starting with total current assets and then subtracting it by inventories and prepaid expenses.
Furthermore, both approaches use current liabilities as the denominator. Here are the mathematical formulas for both:
- Quick ratio = (Cash and cash equivalents + Short-term investment + Accounts receivable)/Current liabilities
- Quick ratio = (Current assets – Inventories – Prepaid expenses) / Current liabilities
The accounts in the above calculation can be found on the balance sheet.
- Cash and cash equivalents represent the most liquid assets, which can be used immediately to pay bills.
- Short-term investments represent placing money in short-term securities, which are highly liquid and can be sold at any time without losing the principal or initial investment.
- Accounts receivable is money owed by customers for sales on credit, in which the company sells goods or provides services to them but has not received cash payment when the financial statements are prepared.
- Inventories and prepaid expenses are deducted from current assets because they are less liquid.
- Current liabilities are obligations expected to be settled within one year or the normal operating cycle, such as trade payables.
How to interpret the quick ratio?
A higher quick ratio is better, indicating the company has sufficient liquid assets to cover its current liabilities. Therefore, the company should have no liquidity problems and be able to pay its bills.
A ratio higher than 1.0 indicates the company can pay off its bills without liquidating inventory or taking on financing such as borrowing from a bank or issuing debt securities.
On the other hand, a lower ratio is less favorable due to the poor ability to meet short-term liabilities. As a result, the company may experience liquidity problems, especially if it is lower than 1.0.
However, it is also not good if the ratio is too high. Usually, a quick ratio between 1,2 and 2 is considered healthy. And, if it is higher than two, it could indicate the company is not using its working capital efficiently because it is not good enough in utilizing its current assets or available short-term financing facilities.
