This post will take a dive into the concept of the quick ratio, its interpretation, and an example of the same.
The quick ratio, commonly referred to as the acid-test ratio, measures the ability of a business to pay its short-term liabilities using only the current assets that are readily convertible into cash. These ‘quick’ assets are, namely, cash and cash equivalents, marketable securities, and accounts receivable.
The formula for the quick ratio is:
As observed above, the quick ratio measures a company’s capacity to pay its current liabilities without needing to sell its inventory or obtain additional financing.
Inventories are excluded from the quick ratio as it may take too long to convert inventory into cash to cover pressing liabilities. Secondly, prepaid expenses are excluded as they cannot be used to pay other liabilities.
Interpretation of Quick Ratio:
Generally, the higher the quick ratio, the better it is for the business. However, one must note that quick ratio is an indicator of solvency of an entity and must be analyzed over a period of time and also in the context of the industry the company operates in.
A quick ratio that is greater than industry average may suggest that the company is investing too many resources in working capital which may be used more profitably elsewhere.
A quick ratio which is lower than the industry average may suggest that the company is taking too much risk by not maintaining an appropriate buffer of liquid resources. Alternatively, a company may have a lower quick ratio due to better credit terms with suppliers than the competitors.
An example of Quick Ratio:
If Co. XYZ holds the following:
- Cash and cash equivalents – $15 million
- Marketable securities – $10 million
- Accounts receivable – $20 million
- Inventory – $35 million
- Short term debt – $10 million
- Accounts payable – $20 million
- Income tax payable – $30 million
The quick ratio will be calculated as given below:
Quick Assets = Cash and cash equivalents + Marketable securities + Accounts receivable
Quick Assets = $45 million
Current Liabilities = Short term debt + Accounts payable + Income tax payable
Current Liabilities = $60 million
Quick Ratio = 0.75.
This means that Co. XYZ will be able to pay 75% of its current liabilities using assets that can be readily converted into cash.