Quick Ratio

Quick ratio is the financial measure that helps in identifying how well it is performing by the capacity of paying its current debts. It aids in spotting the ability of the company to complete short-term liabilities with liquid assets.

What is Quick Ratio?

The quick ratio can be described as the financial ratio that shows the short-term liquidity status as well as measures the strength of the business to carry out the short-term commitments using its available liquid assets. It involves only those liquid assets that may be turned into cash in the time span of 90 days without the influence of the opposite effect on its price.

Quick ratio deals with all types of current assets, excluding inventory and advance payments. For meeting the urgent liabilities, cash is required, but it takes more time to convert inventory into cash. All potential future costs that have been paid for in advance are considered prepaid expenses.

This kind of current asset cannot be leveraged in order to pay for miscellaneous liabilities. The ratio pursues to evaluate the short-term liquidity of a company and fails to include any asset that is hard to convert into cash. As a result, the quick ratio is often known as an acid test.

How to Calculate Quick Ratio?

Quick ratio involves those assets that can be immediately changed into cash. In addition to cash, other examples include marketable securities and accounts receivable. These assets are viewed as “quick assets” because of their swift conversion into cash.

The formula to find the Quick ratio is written below:

Quick Ratio = Liquid Assets / Current Liabilities

Liquid Assets = (Cash and Cash Equivalents + Accounts Receivable + Marketable Securities)

Then the formula become: –

Quick Ratio = (Cash and Cash Equivalents + Accounts Receivable + Marketable Securities)/Current liabilities

The following formula should be applied when a balance sheet does not provide asset break-up:

Quick Ratio = (Current Assets – Prepaid Expenses – Inventory) / Current Liabilities

Let’s say that the quick ratio for the business is 5.5. This shows that the business has the ability to repay the current liabilities 5.5 times, overburdening its available liquidity.

A quick ratio of 1:1 is said to be the optimal outcome.

Components of Quick Ratio

Liquid assets and current liabilities are the two primary components that make up the Quick Ratio.

Liquid Assets

The assets that can be converted into cash immediately or in a short period of time are described as liquid assets. Some of the categories of liquid assets are cash, stocks, bonds, preferred shares, ETF’s, accounts receivable, etc.

Current Liabilities

The short-term obligations that are inclined to become due within the next year. Accounts payable, short-term debt, unpaid bills, and other similar obligations are examples of frequent current liabilities.

Importance of Quick Ratio

The Quick Ratio compares the dollar value of a company’s liquid assets to the corresponding amount of its current liabilities. Current liabilities are commitments or debts owed by a business that need to be paid off within a year.

These debts or obligations are paid off with the help of liquid assets owned by the company. Liquid assets include these assets that can be changed into cash with insignificant effect on their value in the open market.

It is the exact indicator of the firm’s capability or inability to settle its debts and commitments. A robust liquidity ratio is considered the expertise of the organization and assures business growth. Investors, suppliers, and lenders use a company’s fast ratio to assess whether it has sufficient liquid assets to cover its short-term obligations.

A ratio of 1:1, regarded as the ideal quick ratio, shows that the business has in its control sufficient assets that may be quickly converted to cash for paying off the current liabilities.

In case the quick ratio is less than 1, then this is an indication that the company will not pay back the pending current liabilities in the short term completely. Nevertheless, if the ratio becomes more than 1, the company holds onto such liquid assets to carry out the current liabilities swiftly.

Limitations of Quick Ratio

• The Quick Ratio alone might not be enough to analyze a company’s liquidity. Since the ratio is only a mathematical figure and does not offer an estimate of the assets and liabilities being calculated, the study must compare with rivals and current industry norms. It also needs to take account of the cash flow ratio or the current ratio for identifying the accuracy and holistic estimate of the liquidity of the firm.
• Inventory is not included in the ratio’s computation, which works against businesses with large inventories. Supermarkets, for instance, contain a lot of goods that is readily appraised at a price that can be sold. Results would be inaccurate in this case if the ratio just relied on cash or cash equivalents.
• No payment time is taken into consideration. The accounts receivable may eventually turn into bad debt, which is unrecoverable, or they may be retrieved over a protracted period of time. A company’s liquidity would suffer in such a scenario, which is not represented in the Quick Ratio. Within the specified time frame, the ratio also assumes that accounts receivable are easily accessible.
• The corporation can create future estimates thanks to the quick ratio, but since it is based on historical data, the projections may be inaccurate. For example, a business may have a low quick ratio. Nonetheless, the management could maintain strong links with its banks and suppliers, allowing it to fulfill its obligations just as well as a business with a high quick ratio.

Questions to Understand your ability

Q1.) What is the Quick Ratio also commonly known as?

1. Debt-to-Equity Ratio
2. Acid-Test Ratio
3. Inventory Turnover Ratio
4. Cash Flow Ratio

Q2.) Which of the following is NOT considered a liquid asset in the Quick Ratio calculation?

1. Cash and Cash Equivalents
2. Marketable Securities
3. Accounts Receivable
4. Inventory

Q3.)What is the optimal Quick Ratio for a business to be considered financially healthy?

1. 0.5:1
2. 1:1
3. 2:1
4. 3:1

Q4.) Which formula can be used to calculate the Quick Ratio if the balance sheet does not provide asset break-up?

1. (Current Assets + Inventory) / Current Liabilities
2. (Current Assets – Prepaid Expenses – Inventory) / Current Liabilities
3. (Current Assets – Marketable Securities) / Current Liabilities
4. (Cash + Inventory) / Current Liabilities

Q5.) What is a limitation of using the Quick Ratio?

1. It includes inventory in its calculation.
2. It accurately considers the timing of accounts payable.
3. It may not be sufficient to analyze a company’s liquidity by itself.
4. It accounts for all future estimates accurately.

Conclusion

The Quick Ratio is a crucial financial indicator that measures a company’s ability to meet short-term obligations with its most liquid assets, excluding inventory. It is a reliable snapshot of liquidity, offering insights into a company’s financial stability. However, it has limitations, including ignoring inventory and the timing of receivables. While helpful, it should be used alongside other metrics for a comprehensive understanding of a company’s liquidity and financial health.