What is the Quick Ratio?
The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets.
Since it indicates the company’s ability to instantly use its near-cash assets (assets that can be converted quickly to cash) to pay down its current liabilities, it is also called the acid test ratio. An “acid test” is a slang term for a quick test designed to produce instant results.
The quick ratio measures a company’s capacity to pay its current liabilities without needing to sell its inventory or obtain additional financing.
The quick ratio is considered a more conservative measure than the current ratio, which includes all current assets as coverage for current liabilities.
The higher the ratio result, the better a company’s liquidity and financial health; the lower the ratio, the more likely the company will struggle with paying debts.
introduction of Quick Ratio
The quick ratio measures the dollar amount of liquid assets available against the dollar amount of current liabilities of a company. Liquid assets are those current assets that can be quickly converted into cash with minimal impact on the price received in the open market, while current liabilities are a company’s debts or obligations that are due to be paid to creditors within one year.
A result of 1 is considered to be the normal quick ratio. It indicates that the company is fully equipped with exactly enough assets to be instantly liquidated to pay off its current liabilities. A company that has a quick ratio of less than 1 may not be able to fully pay off its current liabilities in the short term, while a company having a quick ratio higher than 1 can instantly get rid of its current liabilities. For instance, a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover each $1 of its current liabilities.
While such numbers-based ratios offer insight into the viability and certain aspects of a business, they may not provide a complete picture of the overall health of the business. It is important to look at other associated measures to assess the true picture of a company’s financial health.
Quick Ratio Formula
The Formula for the Quick Ratio is:
Quick Ratio = Quick Assets / Current Liabilities
Quick assets are those that can be quickly turned into cash. Accounts receivable, cash and cash equivalents, and marketable securities are the most liquid items in a company.
For an item to be classified as a quick asset, it should be quickly turned into cash without a significant loss of value. In other words, a company shouldn’t incur a lot of cost and time to liquidate the asset. For this reason, inventory is excluded in quick assets because it takes time to convert into cash.
Companies usually keep most of their quick assets in the form of cash and short-term investments (marketable securities) to meet their immediate financial obligations that are due in one year.
Current liabilities are a company’s short-term debts due within one year or one operating cycle. Accounts payable is one of the most common current liabilities in a company’s balance sheet. It can also include short-term debt, dividends owed, notes payable, and income taxes outstanding.
Customer Payment Impact on the Quick Ratio
A business may have a large amount of money as accounts receivable, which may bump up the quick ratio. However, if the payment from the customer is delayed due to unavoidable circumstances, or if the payment has a due date that is a long period out, such as 120 days based on terms of sale, the company may not be able to meet its short-term liabilities.
This may include essential business expenses and accounts payable that need immediate payment. Despite having a healthy accounts receivable balance, the quick ratio might actually be too low, and the business could be at risk of running out of cash.
On the other hand, a company could negotiate rapid receipt of payments from its customers and secure longer terms of payment from its suppliers, which would keep liabilities on the books longer. By converting accounts receivable to cash faster, it may have a healthier quick ratio and be fully equipped to pay off its current liabilities.
Whether accounts receivable is a source of quick, ready cash remains a debatable topic, and depends on the credit terms that the company extends to its customers. A company that needs advance payments or allows only 30 days to the customers for payment will be in a better liquidity position than a company that gives 90 days.
Additionally, a company’s credit terms with its suppliers also affect its liquidity position. If a company gives its customers 60 days to pay but has 120 days to pay its suppliers, its liquidity position will be healthy as long as its receivables match or exceed its payables.
The other two components, cash & cash equivalents and marketable securities, are usually free from such time-bound dependencies. However, to maintain precision in the calculation, one should consider only the amount to be actually received in 90 days or less under normal terms. Early liquidation or premature withdrawal of assets like interest-bearing securities may lead to penalties or discounted book value.
Analysis of Quick Ratio
High or Good Quick Ratio
A quick ratio of 1 or above indicates that the company has sufficient liquid assets to satisfy its short-term obligations. An extremely high quick ratio, on the other hand, isn’t always a good sign. This is because a very high ratio could indicate that the company is resting on a significant amount of cash. This idle cash could be better invested in the business or investment schemes to earn interest or returns.
The best quick ratio for a company depends on a variety of factors. Such factors include the industry it operates in, the markets it serves, its maturity, type of business, the cycle of debtors and creditors, and its creditworthiness.
For instance, an MNC with high creditworthiness and maturity in the industry will be able to survive any financial turbulence. Owing to its relationship with creditors, lenders, and debtors, this company will be in a better position to negotiate payment terms and forecast its market. While on the other hand, this is not applicable to a small business. For a small business, the challenges of maintaining liquid assets are tremendous. It deals with other small businesses that may or may not have a strong financial uphold on their cash flow.
Low Quick Ratio
Businesses with a quick ratio of less than 1 have insufficient quick assets to meet their financial obligations in the event of a financial crisis. This makes it difficult for the companies to repay their creditors and lenders.
If a company’s quick ratio is less than one, it suggests it lacks the ability to satisfy all of its short-term obligations. Furthermore, if the company wants to borrow money, it may have to pay exorbitant interest rates.
What’s a good quick ratio?
A company with a quick ratio of less than 1 indicates that it doesn’t have enough liquid assets to fully cover its current liabilities within a short time. The lower the number, the greater the company’s risk.
“A good quick ratio is very dependent on the industry of the company being represented. A good rule of thumb though is to have a quick ratio around or above 1,” says Austin McDonough, an associate financial advisor at Keystone Wealth Partners. “This shows that a company has enough cash or other liquid assets to pay off any short-term liabilities in case they all come due at once.”
The Importance of Quick ratio
- This ratio is one of the major tools for decision-making. It previews the ability of the company to make a settlement of its quick liabilities in a very short notice period.
- This ratio eliminates the closing stock from the calculation, which may not always be necessary to be taken as a liquid, thereby giving a more suitable profile of the company’s liquidity position.
- Since closing stock is separated from current assets and bank overdrafts and cash credit are eliminated from current liabilities, closing stock usually secures them, thereby preparing the ratio to ensure its liquidity position.
- Evaluation of closing stock can be sensitive, and it may not always be at retail value. Therefore, the quick ratio is not impaired, as there is no requirement for the valuation of the closing stock.
- Closing stock can be very seasonal and may vary in quantities over a yearly period. I contemplate, it may collapse or escalate liquidity status. The ratio does away with this issue by ignoring closing stock from the calculation.
- In a sinking industry, which generally may have a very high closing stock level, this ratio will help provide the company with a more authentic repayment ability against the current ratio, including closing stock.
- Because of the major inventory base, one may overstate the short-term financial strength of a company if the current ratio is utilized. By using this ratio, one can tackle this situation. In addition, it will limit companies from getting an additional loan, the servicing of which may not be as simple as reflected by the current ratio.
How to interpret quick ratio
In our example, Company X has a quick ratio of 0.91, meaning it has 91 cents available from quick assets to pay every dollar of current liabilities. Is that good or bad? The answer depends on several factors:
- Industry: Average quick ratios can vary considerably from one industry to the next. In an industry where cash flows are steady and predictable, such as retail, a lower ratio can be fine, because anticipated revenues can be counted on to supply needed cash. On the other hand, in a volatile or seasonal industry, a higher quick ratio will cushion the company against shortfalls in revenue.
- Risk: Some business owners don’t mind taking on risk, including the risk that they might face a cash crunch. For them, a lower quick ratio might be tolerable, whereas a risk-averse owner might require a much higher ratio.
- Growth: A rapidly growing company might need a higher ratio to pay for investments and expanded operations. A steady or declining business can settle for a lower ratio because it has established relationships with suppliers and lenders.
- Economic conditions: During times of economic turmoil, it’s prudent to increase your quick ratio to handle unforeseen shocks. Placid times are the inverse.
- Inventories: Your company might have a type of inventory that is very easy to quickly liquidate without a significant discount. If so, your current ratio (current assets/current liabilities) might be a better indicator of liquidity because the current ratio includes prepaid expenses and inventories as assets, while a quick ratio does not.
- Accounts receivable: If your accounts receivable is difficult to collect, you will want to raise your quick ratio by putting aside additional cash. If you have a short and predictable accounts receivable cycle, you can probably lower your quick ratio.
- Too high: A quick ratio that is too high means that some of your money is not being put to work. This indicates inefficiency that can cost your company profits. If you don’t have a special need for a high ratio, you will want to lower it to at least the industry average.
Business owners can improve their quick ratios by putting more of their net profits into cash, cash equivalents and marketable securities. They can also reduce their liabilities by cutting expenses and repaying debt. Conversely, if their quick ratio is too high, they can invest some of their extra quick assets into projects that will grow the business or make it more efficient.
From a lender’s point of view, the higher the quick ratio, the better. A higher quick ratio indicates the borrower will be able to make principal and interest payments even if the business runs into unexpected expenses or reduced revenues. Lenders prefer creditworthy borrowers and might reward them with larger loans and/or more favorable terms. The quick ratio is one of three popular measures of liquidity, the other two being the current ratio and the cash ratio.
We note that current assets may contain a large inventory, and prepaid expenses may not be liquid. Therefore, including stock, such items will skew the current ratio from an immediate liquidity point of view. Quick ratio solves this problem by not taking inventory into account. It only considers the most liquid assets , including money and cash equivalents, and receivables.
A higher than the average industry ratio may imply that the company is investing too much of its resources in the business’s working capital, which may be more profitable elsewhere. However, if the quick ratio is lower than the industry average, it suggests that the company is taking a high amount of risk and not maintaining adequate liquidity.