What is the ‘Quick Ratio’
The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets. For this reason, the ratio excludes inventories from current assets, and is calculated as follows:
Quick ratio = (current assets – inventories) / current liabilities, or
= (cash and equivalents + marketable securities + accounts receivable) / current liabilities
The quick ratio measures the dollar amount of liquid assets available for each dollar of current liabilities. Thus, a quick ratio of 1.5 means that a company has $1.50 of liquid assets available to cover each $1 of current liabilities. The higher the quick ratio, the better the company’s liquidity position. Also known as the “acid-test ratio” or “quick assets ratio.”
BREAKING DOWN ‘Quick Ratio’
<P.For example, consider a firm with the following current assets on its balance sheet:
Cash $5 million, marketable securities $10 million, accounts receivable $15 million, inventories $20 million.
This is offset by current liabilities of $20 million.
The quick ratio in this case is 1.5 and the current ratio is 2.5.
The quick ratio is more conservative than the current ratio because it excludes inventories from current assets. The ratio derives its name presumably from the fact that assets such as cash and marketable securities are quick sources of cash. Inventories generally take time to be converted into cash, and if they have to be sold quickly, the company may have to accept a lower price than book value of these inventories. As a result, they are justifiably excluded from assets that are ready sources of immediate cash.
Whether “accounts receivable” is a source of ready cash is debatable, however, and depends on the credit terms that the company extends to its customers. A firm that gives its customers only 30 days to pay will obviously be in a better liquidity position than one that gives them 90 days. But the liquidity position also depends on the credit terms the company has negotiated from its suppliers. For example, if a firm gives its customers 90 days to pay, but has 120 days to pay its suppliers, its liquidity position may be reasonable.
The other issue with including accounts receivable as a source of quick cash is that unlike cash and marketable securities – which can typically be converted into cash at the full value shown on the balance sheet – the total accounts receivable amount actually received may be slightly below book value because of discounts for early payment and credit losses.