What Is A Quick Ratio?
The quick ratio is a type of liquidity ratio, that measures a company’s short-term liquidity. The quick ratio indicates a company’s ability to repay its short-term obligations using its most liquid assets. These assets include; cash, marketable securities, account receivable, etc.
The quick ratio is quite similar to the current ratio but provides a more conventional approach to the liquidity position of a company as it does not include inventory, as it does not consider inventory as sufficiently liquid. The quick ratio is also known as the acid-test ratio.
Table of Contents
Formula And Calculation of Quick Ratio
The Formula for the quick ratio is:
Quick Ratio = (Current Assets – Inventory – Prepaid expenses)/Current Liabilities
Quick Ratio = (Cash & equivalents + marketable securities + accounts receivable)/Current liabilities
To calculate the quick ratio, analysts have to find each of the components from the assets section in the company’s balance sheet. Put all these values on the formula to calculate the quick ratio.
The quick ratio does not include the inventory because for many companies, in order to sell all of their inventory in 90 days or less is very difficult and would have to apply high discounts to lure the customers to buy the product quickly.
Only the accounts receivables that can be collected within 90 days are considered. Accounts receivable is the money that is the money owed to a company by its customers for goods or services that are already delivered.
Suppose a company has:
- Cash: $100 million
- Account Receivable: $50 million
- Marketable Security: $70 million
- Current Liability: $110 million
Then ths Quick ratio of the company is:
Quick Ratio = ($100 million + $50 million + 70 million)/$110 million = 2.0
The company has a quick ratio of 2:1, which means the company can pay over 2 times its liability using its most liquid assets.
Importance of Quick Ratio
- The quick ratio is one of the easiest and reliable ways of measuring a business’s liquidity. It is mostly used by the creditors and lenders to evaluate a firm, if it is creditworthy or not.
- The quick ratio is very important to analyze the inventory heavy company, as the current ratio includes inventory and quick ratio ensures that no such misleading information is portrayed regarding the liquidity of a company.
- A high quick ratio also portrays that the company is well prepared for uncertainties and to any changes in business environments, that attract investors also.
- The quick ratio also reduces the error as it excludes the inventory and calculation of inventory may possess human error.
Limitation of Quick Ratio
- One of the major limitations of the quick ratio is that it can’t be used to compare companies from industries and can only be a gauge company from similar industries.
- The quick ratio is only a mathematical value, that does not provide any context of assets and liabilities of a company
- The ratio ignores inventory from its calculation, which may not be appropriate for some businesses where inventory may be valued at a marketable price.
- The quick ratio also ignores the level and the timing of the cash flows, which actually would be a major factor while determining the company’s ability to pay liabilities when they are going to default.
- This ratio considers accounts receivables as the most liquid and can be converted to cash easily, which may not be in some cases.
Mostly, the quick ratio or the acid test ratio should be 1:1 or even higher; but, this solely depends upon the industry. Generally, the higher the quick ratio, the greater a company’s liquidity. The ratio is for the rest of the company’s viability, but do not give a clear picture of the company’s health.