Quick ratio

Key Takeaways

1. Quick Ratio measures the company’s ability to pay its current liabilities without selling its assets or getting any additional financing.
2. Quick Ratio is considered a more conservative ratio than Current Ratio, which is also another type of liquidity ratio, as it uses quickly available or liquid assets.
3. For a company, the higher the quick ratio, the higher is the capacity of the company to meet its short-term liquidity requirements; the lower the quick ratio, the more likely the company will struggle to pay the debts.

What is Quick Ratio?

·        Quick Ratio is also known as Acid Test Ratio

·        Type of liquidity ratio

·        Measures the short liquidity of an enterprise.

·        Quick Ratio indicates the company’s ability/capacity to pay all its current liabilities by using its near cash or quick assets which can be quickly converted to cash.

Quick Ratio Formula:

Quick Ratio = (Liquid Assets)/(Current Liabilities)

 More Understanding of Quick Ratio

Quick Ratio measures the ability of a company to pay its debt or current liabilities when they fall due with only quick assets. 

Quick Assets are the current assets that can be quickly converted into cash in a short term period with minimal impact on the price received in an open market. Quick Assets are cash, cash equivalents, saleable or marketable securities, short term investments, and current accounts receivables. Current liabilities are a company’s short term obligations which are due within one year of the date of the company’s balance sheet.

Why does Quick Ratio Matter?

It is necessary that a company should have enough cash to cover non-operating expenses, interest expenses, account payable, and other bills when they become due. As earlier mentioned the higher the ratio, the company is financially more secured.

If the ratio is much higher, then maybe the company is holding immoderate liquid assets, which means a company is able to convert receivables quickly into cash, has capacity to manage financial obligations easily and such company is experiencing excellent topline growth. If the ratio is too low, then it indicates that a company has liquidity problems, which means generally the company is struggling to maintain and grow sales, paying bills quickly or have problems in receivables collection.

Quick Ratio Example

Quick ratio can be calculated by using a company’s balance sheet.

Let’s assume Cynthia’s ShoeMall is applying for loan to construct its main office. The bank asks Cynthia to give a detailed balance sheet, so it can assess the quick ratio for the company.

Following is the balance sheet data:

·        Cash and Equivalents: Rs. 20,000

·        Account Receivable: Rs. 15,000

·        Inventory: Rs. 4,000

·        Stock Investments: Rs. 3,000

·        Prepaid taxes: Rs. 700

·        Current Liabilities: Rs.30,000

Quick Ratio can be calculated as follows:

(Cash and Equivalents) + Short-Term Investment + Account Receivable

= 20,000 + 3,000 + 15,000 = 38,000

∴ Rs.38,000 / Current Liabilities (Rs.30,000) = 1.26

From the calculation above, the quick ratio is 1.26. This quick ratio indicates that Cynthia can pay off all her current liabilities with quick assets and still can have some quick assets to go on.

 Quick Ratio vs. Current Ratio

The quick ratio and current ratio are both formulated to measure the ability of a company or business to pay for its current liabilities i.e. to measure company’s short term liquidity. Although they both have similar functions to measure Company’s financial health, they are slightly different. The quick ratio is considered a more conservative ratio than the current ratio. The difference between the two ratios is that the quick ratio focuses on the liquid assets and gives a better picture how well a company can pay its debt easily without needing any additional financing.