What is the ‘Quick Ratio’
The quick ratio is an indicator of a company’s short-term liquidity, and measures a company’s ability to meet its short-term obligations with its most liquid assets. Because we’re only concerned with the most liquid assets, the ratio excludes inventories from current assets. Quick ratio is calculated as follows:
Quick ratio = (current assets – inventories) / current liabilities, or
Quick ratio = (cash and equivalents + marketable securities + accounts receivable) / current liabilities
The quick ratio is also known as the acid-test ratio.
BREAKING DOWN ‘Quick Ratio’
Quick Ratio vs. Current Ratio
Quick assets are current assets that can be converted to cash within 90 days or in the short-term. The quick ratio is a liquidity ratio that measures a company’s ability, using its quick assets, to pay off its current debt as they come due. The ratio derives its name presumably from the fact that assets such as cash and marketable securities are quick sources of cash. Therefore, only assets that can be liquidated quickly are factored into the equation. Inventory, even though it is a current asset, is not considered a quick asset since it cannot be converted to cash within a very short time frame. Furthermore, if inventories have to be sold quickly, the company may have to accept a lower price than the book value. This is the difference between the quick ratio and the current ratio, which includes all current assets in its calculation including inventory.
Practical Example of a Quick Ratio
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.
Interpreting the Quick Ratio
While a quick ratio lower than 1 does not necessarily mean the company is going into default or bankruptcy, it could mean that the company is relying heavily on inventory or other assets to pay its short term liabilities. The higher the quick ratio, the better the company’s liquidity position. However, too high a quick ratio may indicate that the company has too much cash sitting in its reserves. It may also mean that the company has a high accounts receivables, indicating that the company may be having problems collecting on its account receivables.
Whether accounts receivable is a source of quick 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 offered for early payment and credit losses.