Calculating the Quick Ratio
The quick ratio, sometimes called the quick assets ratio or the acid-test, is an indicator of a business' short-term liquidity, or ability to meet its short-term obligations, such as accounts payable, wages and taxes, with readily available cash. It is a more stringent test of liquidity than the current ratio. This is because it removes inventory from the equation. Inventory is the least liquid of all the current assets.
A business has to find a buyer if it wants to liquidate inventory, or turn it into cash. Finding a buyer is not always easy.
Stated differently, the quick ratio puts a dollar amount to liquid assets available for each dollar of 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.
Conversely, a quick ratio of .5X would indicate that the business could only satisfy half of it's current liabilities.
Calculation of the Quick Ratio
The quick ratio is calculated from balance sheet data.
Quick Ratio = Current Assets - Inventory / Current Liabilities
Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivable*) / Current Liabilities
*A variable to be considered is the terms the business extends to its customers.
For instance, terms may include early payment discounts. Then the amount of accounts receivable shown may be overstated. Or, liabilities may be due now, while the AR cash may be 30 - 45 days out.
Quick Ratio = (Current Assets - Inventory - Advances - Prepayments) / Current Liabilities
Each formula should yield the same answer.
If a business firm 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 is important. It means that the firm can pay its current liabilities from its current assets (less inventory) one and a half times over.
Interpretation and Analysis
This is obviously a good position for the firm to be in. It can meet its short-term debt obligations with no stress. If the quick ratio was less than 1.00X, then the firm would have to sell inventory to meet its obligations So, a quick ratio great than 1.00X is better than a quick ratio of less than 1.00X with regard to maintaining liquidity and not being forced into the position of having to sell inventory.
- Back: What is the current ratio and how is it calculated?
- Forward: What is net working capital and how is it measured?
- Tutorial: An Analysis of a Company's Liquidity Position Using Financial Ratios
Quick Ratio results should be viewed in the context of the specific industry of an organization. Certain business sectors traditionally have a very low quick ratio. For instance, companies in the retail sector are usually able to negotiate favorable credit terms with suppliers leading to relatively high current liabilities in comparison to their liquid assets.
Conversely, industries which expand at a very fast pace, such as fast food, require higher levels of liquid resources at their disposal to satisfy their investment needs.