The quick ratio is a financial metric used for determining how well a company can pay off its current debts. It helps in identifying the company's capacity to fulfil short-term obligations with liquid assets.
What is Quick Ratio
Quick Ratio acts as a company’s indicator for its short-term liquidity position, and it measures the ability of the business to discharge its short-term obligations with the liquid assets at its disposal. It includes only such liquid assets that may be converted into cash within 90 days without bearing an adverse impact on its price.
Quick Ratio takes into account all kinds of current assets except inventory and prepaid expenses. Inventories usually take a much longer time to be liquidated into cash to meet the immediate liabilities. Prepaid expenses include all such prospective expenses that may arise and for which payment has been made in advance.
Such current assets cannot be utilised in order to pay for other liabilities. The ratio seeks to assess the short-term liquidity of a company and leaves out any asset that cannot be easily converted to cash. Hence, the quick ratio is also referred to as an Acid Test as well.
Calculation of Quick Ratio
Quick Ratio includes such assets which can be readily converted to cash. Some examples include marketable securities and accounts receivable, apart from cash. These assets are considered to be “Quick Assets” because of their easy convertibility into cash.
Quick Ratio Formula is mentioned below –
Quick Ratio = Liquid Assets / Current Liabilities
or
Quick Ratio = (Cash and Cash Equivalents + Accounts Receivable + Marketable Securities) / Current Liabilities
When asset break-up is not mentioned in a balance sheet, the following formula should be used –
Quick Ratio = (Current Assets – Prepaid Expenses – Inventory) / Current Liabilities
Suppose the quick ratio for a business is 4.5. This would indicate that the business has the repayment capacity of its current liabilities 4.5 times over utilising its liquid assets.
A result of 1:1 is considered to be the ideal ratio of quick ratio.
Components of Quick Ratio
There are mainly 2 components included in Quick Ratio, namely Liquid Assets and Current Liabilities-
Liquid Assets
Liquid Assets or Quick Assets are those assets that can be easily converted into cash within a short duration. Some of the few types of liquid assets are cash, marketable securities, accounts receivable, etc.
Current Liabilities
Current liabilities are the kind of short-term obligations that are likely to become due in the next year. Some of the common current liabilities are accounts payable, short-term debt, outstanding expenses etc.
Quick Ratio Example
Consider that a clothing boutique is applying to a financial institution for a loan in order to remodel its store. A lender would need to compute the quick ratio and ask for the balance sheet from the store owner.
The balance sheet is illustrated below.
| Cash | Rs. 10,000 |
| Inventory | Rs. 5,000 |
| Accounts receivable | Rs. 5,000 |
| Investments in stocks | Rs. 1000 |
| Prepaid taxes | Rs. 500 |
| Current liabilities | Rs. 15,000 |
Quick Ratio = (10,000 + 1000 + 5000) / 15000
= 16000 / 15000
= 1.07
The quick ratio of the business is 1.07, which indicates that the owner can pay off all the current liabilities with the liquid assets at their disposal and still be left with a few assets.
Difference Between Current Ratio and Quick Ratio
Even though both the current ratio and quick ratio measure the financial health of a company, there are certain differences between the two. Let's dissect the current ratio vs quick ratio in detail-
Current Ratio
Current Ratio relates to measuring the ability of a company to pay its short-term or current liabilities with that of its short-term assets such as inventory, cash, and receivables.
Current assets on the balance sheet of a company will represent all such assets that may be converted into cash within a period of 1 year. Current assets cover accounts receivable, inventory, marketable securities, cash and cash equivalents, and prepaid expenses.
A company’s current liabilities include accounts payable, short-term debt along accrued liabilities, among others.
Current ratio is calculated in the following manner –
Current Ratio = Current Assets / Current Liabilities
If the current ratio of a company amounts to less than 1, creditors can perceive the business as a risk. This is because the ratio indicates that the current assets held by a company are insufficient to meet its current liabilities. Thus, it is incapable of discharging all short-term obligations.
Quick Ratio
Quick ratio, on the other hand, omits inventory and other such assets, which cannot be converted into cash quickly. In most cases, inventories take a much longer time to be liquidated. For converting inventories to cash, it will have to be sold to the customer.
In the course of the collection process, customers may also purchase other inventories on credit, which may further delay the payment. Due to these factors, inventories are excluded from the quick ratio as opposed to the current ratio.
Importance of Quick Ratio
Quick Ratio assesses the dollar amount of the various liquid assets at the disposal of a company against the equivalent amount of its existing liabilities. A company’s current liabilities include its obligations or debts, which must be cleared within the year.
Such debts or obligations are discharged by liquid assets held by the company. Liquid assets involve such assets that may be converted into cash with negligible impact on their price in the open market.
It is precisely an indicator of a company’s ability or limitation in discharging its debts and obligations. A healthy liquidity ratio is taken as the competence of the organisation and assures healthy business performance, which may eventually lead to the sustainable growth of an organisation. A company’s lenders, suppliers and investors rely on quick ratio to determine if it has enough liquid assets for discharging its short-term liabilities.
Ratio of 1:1 is held to be the ideal quick ratio indicating that the business has in its possession enough assets that may be immediately liquidated to pay off the current liabilities.
If it is less than 1, the low quick ratio will not allow the company to pay off its current liabilities outstanding in the short term entirely. However, if the ratio is higher than 1, the company retains such liquid assets to discharge its current liabilities immediately.
Limitations of Quick Ratio
- Quick Ratio on its own may not suffice in analysing the liquidity of a company. The analysis must undertake a comparison with competitors as well as existing industry standards since the ratio is entirely a mathematical value that does not provide an estimation of assets and liabilities under calculation.
It should also take into consideration the cash flow ratio or the current ratio for determining an accurate and comprehensive estimation of the liquidity of a company.
- The ratio excludes inventory from the calculation, which is counterproductive for companies with high inventory.
For example, supermarkets have high inventory, which is easily valued at a marketable price. In such a situation, if the ratio only depends on cash or cash equivalent, results would lack accuracy.
- It does not take into account any period for payments. It is entirely possible that the accounts receivables eventually become bad debt, which cannot be recovered, or that recovery may happen after a long delay. Such a situation would adversely impact the liquidity of a company which is not reflected in the Quick Ratio.
The ratio also presumes that accounts receivables are readily available within the decided time period.
- Quick ratio enables the company to make future projections, but it is calculated on past data, which may lead to such projections being fallacious.
For instance, a company may have a low quick ratio. However, the management may retain a robust relationship with its suppliers and banks which would enable it to meet its liabilities as effectively as a company with a
high quick ratio.
