The quick ratio indicates how well a company can cover its immediate debts using its most readily available assets. It's computed by dividing a firm's cash, cash equivalents, marketable securities, and accounts receivable by its total current liabilities.
Traders and short-term investors can rely on different financial measures to evaluate if a company’s shares are worth investing in. The quick ratio is one such measure that helps you assess a company’s short-term financial liquidity. Let us take a closer look at the meaning of quick ratio, analyse the formula of the quick ratio and check out some quick ratio examples.
What is the quick ratio?
The quick ratio, also called the quick liquidity ratio or the acid-test ratio, the quick ratio is a financial indicator that compares a company’s quick or liquid assets with its current liabilities. It measures how capable a company is of paying off its current liabilities with its liquid or quick assets alone.
Formula of quick ratio
As its name indicates, the quick ratio is equal to the quick assets of a company divided by its current liabilities. The formula for the quick ratio is as follows:
Quick ratio = Liquid assets ÷ Current liabilities |
To calculate the liquid assets of a company, you can use any of the following two formulas:
Liquid assets = Cash and cash equivalents + Marketable securities + Accounts receivable or Liquid assets = Current assets – Inventory – Prepaid expenses |
Also read - What is ratio analysis?
How to calculate quick ratio
To better understand how this indicator works, let us take an example of the quick ratio and how it is calculated. Consider the following data for a company.
Particulars |
Value |
Cash and cash equivalents |
Rs. 50,000 |
Marketable securities |
Rs. 1,50,000 |
Accounts receivable |
Rs. 80,000 |
Current liabilities |
Rs. 1,20,000 |
Plugging in the above values in the formula for the quick ratio, we have:
Quick ratio:
= Liquid assets ÷ Current liabilities
= (Cash and cash equivalents + Marketable securities + Accounts receivable) ÷ Current liabilities
= Rs. (50,000 + 1,50,000 + 80,000) ÷ Rs. 1,20,000
= Rs. 2,80,000 ÷ Rs. 1,20,000
= 2.33
This means that the company can cover its current liabilities with its quick assets 2.33 times over.
Quick ratio example
Imagine a scenario where a small retail business seeks financing to renovate its storefront. To assess the business's ability to meet short-term obligations, a lender would calculate the quick ratio and request the company's balance sheet.
Here’s an example of what the balance sheet might show:
- Cash: Rs. 10,000
- Marketable securities: Rs. 1,000
- Accounts receivable: Rs. 5,000
- Inventory: Rs. 5,000
- Prepaid taxes: Rs. 500
- Current liabilities: Rs. 15,000
The quick ratio is calculated as:
Quick ratio = (10,000 + 1000 + 5000) / 15000
= 16000 / 15000
= 1.07
Substituting the values: A quick ratio of 1.07 suggests that the business can settle all current debts using its liquid assets and still have additional assets remaining. This metric indicates the business’s short-term liquidity strength to potential lenders.
The key components of the quick ratio
As the formula for the quick ratio indicates, you only need to compare two key metrics: the liquid assets of a company and its current liabilities. Here is what they mean.
- Liquid assets
The liquid assets of a company, also known as its quick assets, are those assets that can easily be liquidated. Some examples of such liquid assets include cash and cash equivalents, accounts receivables and any marketable securities like bonds, stocks and commercial papers. It is important to note that liquid/quick assets do not include other current assets like inventory, prepaid expenses and the like. - Current liabilities
The current liabilities of a company make up the denominator in the formula for the quick ratio. These liabilities are typically due to be repaid over the short term, generally within one year. Some common examples of current liabilities include salaries and wages due to employees, interest due on short-term debts, accounts payables and taxes. The portion of a company’s long-term debt that needs to be repaid within the year is also a part of this component.
Advantages of quick ratio
The quick ratio is crucial because it helps you understand whether a company is capable of repaying its current liabilities with its liquid assets. A ratio of 1 or more is considered to be a good sign, while any value below 1 means that the company has trouble with its liquidity.
What is an ideal quick ratio?
In broad terms, a favorable quick ratio is typically considered to be above 1 or 1:1. A ratio of 1:1 signifies that a company possesses liquid assets equal to its current liabilities. A higher ratio indicates that the company could settle its current obligations multiple times over, reflecting stronger liquidity and financial health.
Also read: What is Current Ratio?
Analysis of Quick Ratio
High or Favorable Quick Ratio
A Quick Ratio of 1 or higher signifies that the company possesses ample liquid assets to meet its short-term liabilities. However, an excessively high ratio may not always be advantageous. It could indicate that the company is holding a significant amount of idle cash that could be more effectively utilised through investments or business expansion to generate returns.
The optimal Quick Ratio varies depending on several factors such as industry dynamics, market conditions, business maturity, customer and supplier credit cycles, and overall financial health.
For example, multinational corporations with strong credit ratings and established market positions can navigate financial uncertainties more effectively. They can negotiate favorable payment terms with suppliers and creditors, and accurately forecast market trends. Conversely, small businesses face greater challenges in maintaining sufficient liquid assets, especially when dealing with smaller partners who may have less stable cash flows.
Low Quick Ratio
Companies with a Quick Ratio below 1 lack adequate quick assets to settle their short-term financial obligations during a financial crisis. This jeopardises their ability to repay creditors and lenders promptly.
A Quick Ratio below 1 indicates that the company may struggle to fulfill all its immediate financial commitments. Additionally, if the company seeks external financing, it may face higher interest rates due to perceived higher risk.
Limitations of Quick Ratio
- The Quick Ratio alone may not provide a sufficient analysis of a company's liquidity. It should be compared with competitors and industry standards, as it is purely a numerical value without considering the nature of assets and liabilities.
It is essential to consider the Cash Flow Ratio or Current Ratio for a more accurate assessment of liquidity. - Excluding inventory from the calculation is a drawback, especially for companies with substantial inventory. For example, supermarkets have significant inventory easily valued at marketable prices. Relying solely on cash or cash equivalents for the ratio may lead to inaccurate results.
- The Quick Ratio does not factor in payment periods. Accounts receivable may turn into bad debts or face delays in recovery, adversely affecting liquidity beyond what the Quick Ratio indicates. It assumes accounts receivable are promptly collectible.
- Although the Quick Ratio helps in forecasting, it relies on historical data, potentially leading to misleading projections. A company with a low Quick Ratio might effectively manage its liabilities through strong relationships with suppliers and banks, despite its apparent liquidity challenges.
Current ratio vs quick ratio: The key differences
Although the two are often confused with one another, the quick ratio is different from the current ratio. Here is a summary of the key differences.
Particulars |
Quick Ratio |
Current Ratio |
Meaning |
Measures a company's capacity to repay its short-term obligations with its most liquid assets |
Measures a company's capacity to repay its short-term obligations with all its current assets |
Formula |
(Cash + Marketable securities + Accounts receivable) ÷ Current liabilities |
Total current assets ÷ Current liabilities |
Components |
Includes cash, marketable securities and accounts receivables |
Includes cash, marketable securities, accounts receivables, inventory and other current assets |
Inventory |
Excludes inventory from the calculation |
Includes inventory in the calculation |
Purpose |
Provides a more stringent test of liquidity by excluding inventory, which may not be readily convertible to cash |
Offers a broader overview of a company's liquidity by including all the assets that can be converted to cash within a year |
Sensitivity |
More sensitive to changes in inventory levels and accounts receivables |
Less sensitive to changes in inventory and other current assets |
Conclusion
The quick ratio is an important financial metric to consider if you want to invest in a company over the short term. It gives you more clarity about the company’s liquidity and financial strength. Keep in mind that the higher the quick ratio, the better the company’s liquidity is. That said, you must also evaluate other indicators like the current ratio and cash ratio to make a more informed decision.
