The quick ratio—sometimes called the quick assets ratio or the acid-test—serves as an indicator of a company's short-term liquidity, or its ability to meet its short-term obligations. In other words, it tests how much the company has in assets to pay off all of its liabilities.
Assets include cash, accounts receivable, short-term investments, and inventory. The quick ratio offers a more stringent test of a company's liquidity than the current ratio.
Explaining the Acid Test
The acid test or quick ratio formula removes a firm's inventory assets from the equation. Inventory is the least liquid of all the current assets because it takes time for a business to find a buyer (or buyers) if it wants to liquidate the inventory and turn it into cash. If a company's quick ratio comes out significantly lower than its current ratio, this means the company relies heavily on inventory and may be sorely lacking other liquid assets.
The quick ratio assigns a dollar amount to a firm's liquid assets available to cover each dollar of its current liabilities. Thus, a quick ratio of 1.75X means that a company has $1.75 of liquid assets available to cover each $1 of current liabilities. The higher the quick ratio, the better the company's liquidity position.
Calculating the Quick Ratio
You can calculate the quick ratio from balance sheet data using this formula:
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Current assets might include cash and equivalents, marketable securities and accounts receivable.
The quick ratio has a weakness in that it does not account for time. For example, say a business extends credit terms to its customers. The payment terms may include early payment discounts, but these discounts haven't been reflected in the balance sheet numbers because the customers have not yet paid.
This means the accounts receivable balance on the company's balance sheet could be overstated. Also, the company's current liabilities might be due now, while its incoming cash from accounts receivable may not come in for 30 to 45 days.
If a business has $200 in current assets and $50 in inventory and $100 in current liabilities, the calculation is $200-$50/$100 = 1.50X. The "X" (times) part at the end means that the firm can pay its current liabilities with its current assets (less inventory) one and a half times over.
Interpreting the Results
In many cases, a firm with a 1.5X quick ratio would be in a good position financially, with the ability to meet its short-term debt obligations with ease. If the quick ratio was less than 1.00X, then the firm would have to sell inventory to raise some cash to meet its obligations
A quick ratio greater than 1.00X puts the company in a better position than a quick ratio of less than 1.00X with regard to maintaining liquidity and not having to depend on selling inventory to pay its liabilities.
You should consider quick ratio results within the context of a company's specific industry and its group of competitors. Certain business sectors traditionally have a very low quick ratio.
Companies in the retail sector usually negotiate favorable credit terms with suppliers, giving them more time to pay, leading to relatively high current liabilities in comparison to their liquid assets.
For example, many consider a 1:1 ratio standard and a quick ratio of .5X would seem to indicate that a business could only satisfy half of its current liabilities. This may be problematic in some industries, while normal in others. High-volume retail stores such as Wal-mart and Target, for example, have both quick-and current ratios below 1.