Quick Ratio

Learn about the concept of the quick ratio, a crucial financial metric that assesses a company’s short-term liquidity position.
Quick Ratio
3 mins read
26 March 2024

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 this ratio, analyse the formula of the quick ratio and check out some quick ratio examples.

What is 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 to calculate the 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


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.

Calculating the quick ratio: An example

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.

Why is the quick ratio significant?

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.

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.

Frequently asked questions

What is the meaning of the quick ratio?

The quick ratio is a financial indicator that measures a company’s short-term liquidity. It evaluates how capable a company is of repaying its short-term debts, typically those that are due within the year.

How do I calculate the quick ratio?

The formula of the quick ratio involves dividing a company’s quick assets by its current liabilities.

What is the ideal range for the quick ratio?

Generally, a quick ratio of 1 or more is considered ideal because it indicates that a company has enough quick assets to cover its short-term liabilities. The higher the quick ratio, the better it is.

What does it mean if the quick ratio is less than 1?

If the quick ratio is below 1, it is a sign of poor financial liquidity. It means that the company does not have enough quick assets to meet its current liabilities.

Is the quick ratio the same as the current ratio?

No, the two ratios are different. The formula of the quick ratio only considers the liquid or quick assets of a company. The current ratio, however, takes into account all the current assets.

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