Even well-run businesses may experience unforeseen cash flow issues that require them to sellassets to cover expenses — after all, revenue is rarely static month to month, anddisastershappen. But how do you as a business leader or potential investor know how selling an asset,like securities or accounts receivable, will affect your financial standing?
The quick ratio is one way to measure a business’s ability to quickly convertshort-termassets into cash. Also known as the “acid test ratio,” the quick ratio is anindicator of acompany’s liquidity and financial health.
What Is Quick Ratio?
What if a company needs quick access to more cash than it has on hand to meet financialobligations? Perhaps a hurricane knocked out power for several days, forcing the business toclose its doors and lose sales, or maybe a customer is late making a large payment —butpayroll still needs to be run, and invoices continue to flow in.
Most businesses experience sporadic cash flow problems. Thequick ratio measures a company’s ability to convert liquid assets into cash to pay forshort-term expenses and weather emergencies like these.
Key Takeaways
- The quick ratio measures a company’s ability to quickly convert liquid assets intocashto pay for its short-term financial obligations.
- A positive quick ratio can indicate the company’s ability to survive emergenciesorother events that create temporary cash flow problems.
- Lenders and investors use the quick ratio to help decide whether a business is a goodbet for a loan or investment.
- The quick ratio is considered a conservative measure of liquidity because it excludesthe value of inventory. Thus it’s best used in conjunction with other metrics,such asthe current ratio and operating cash ratio.
Quick Ratio Explained
The quick ratio represents the extent to which a business can pay its short-term obligationswith its most liquid assets. In other words, it measures the proportion of abusiness’scurrent liabilities that it can meet with cash and assets that can be readily converted tocash.
The quick ratio is also known as the acid test ratio, a reference to the fact that it’susedto measure the financial strength of a business. A business with a negative quick ratio isconsidered more likely to struggle in a crisis, whereas one with a positive quick ratio ismore likely to survive.
Quick Ratio Formula
The quick ratio formula is:
Quick ratio = quick assets / currentliabilities
Quick assets are a subset of the company’s current assets. You can calculate theirvalue thisway:
Quick assets = cash & cash equivalents+ marketable securities + accounts receivable
If it’s not possible to identify all of these individual asset types on the balancesheet,the total value of quick assets can be deduced from the value of current assets using thisformula:
Quick assets = current assets –inventory –prepaid expenses
You can find the value of current liabilities on the company’s balance sheet.
What Is Included in the Quick Ratio?
The quick ratio is the value of a business’s “quick” assets divided by itscurrentliabilities. Quick assets include cash and assets that can be converted to cash in a shorttime, which usually means within 90 days. These assets include marketable securities, suchas stocks or bonds that the company can sell on regulated exchanges. They also include accountsreceivable — money owed to the company by its customers under short-termcreditagreements.
Why isn’t inventory included?
Stock, whether clothing for a retailer or automobiles for a car dealer, is not included inthe quick ratio because it may not be easy or fast to convert your inventory into cash quicklywithout significant discounts. The quick ratio also doesn’t include prepaid expenses,which,though short-term assets, can’t be readily converted into cash.
Quick Ratio vs Current Ratio
The quick ratio is one way to measure business liquidity. Another common method is thecurrent ratio. Whereas the quick ratio only includes a company’s most highly liquidassets,like cash, the current ratio factors in all of a company’s current assets — including those that may not be aseasyto convert into cash, such as inventory. Both ratios compare assets against thebusiness’scurrent liabilities.
Current liabilities are defined as all expenses a business is due to pay within one year. Thecategory can include short-term debts, accounts payable and accrued expenses, which aredebits that the company has recognized on the balance sheet but hasn’t yet paid.
Quick Ratio Analysis
The quick ratio measures a company’s ability to raise cash quickly when needed. Forinvestorsand lenders, it’s a useful indicator of a company’s resilience. For businessmanagers, it’sone of a suite of liquidity measures they can use to guide business decisions, often withhelp from their accounting partner.
Other important liquidity measures include the current ratio and thecash ratio.
The quick ratio is a stricter measure of liquidity than the current ratio because it includesonly cash and assets the company can quickly turn into cash. However, the quick ratio is notas strict a measure as the cash ratio, which measures the ratio of cash and cash equivalentsto current liabilities. Unlike the quick ratio, the cash ratio excludes accounts receivable.
The quick ratio also doesn’t say anything about the company’s ability to meetobligationsfrom normal cash flows. It measures only the company’s ability to survive a short-terminterruption to normal cash flows or a sudden large cash drain.
How to Calculate Quick Ratio
Financial managers can calculate their company’s quick ratio by identifying therelevantassets and liabilities in the company’saccountingsystem. Investors and lenders can calculate a company’s quick ratio from itsbalancesheet. Here’s how:
- From the balance sheet, find cash and cash equivalents, marketable securities andaccounts receivable, which you’ll sometimes see listed as “tradedebtors” or “tradereceivables.” These are the quick assets.
- On the balance sheet, find “current liabilities.”
- Add up the quick assets. Then divide them by current liabilities.
The result is the quick ratio.
Quick Ratio Examples
| Company A has a balance sheet that looks likethis: | |
|---|---|
| Current assets | |
| Accounts receivable | $ 150,000 |
| Marketable securities | $ 5,000 |
| Cash and cash equivalents | $ 10,000 |
| Total current assets | $ 165,000 |
| Current liabilities | |
| Accounts payable | $ 125,000 |
| Accrued expenses | $ 10,000 |
| Other short-term liabilities | $ 2,500 |
| Total current liabilities | $ 137,500 |
This company’s current assets consist entirely of quick assets, so calculating thequickratio is straightforward:
Quick ratio = quick assets / currentliabilities
= 165,000/137,500
= 1.2
| In contrast, Company B has a balance sheet thatlooks like this: | |
|---|---|
| Current assets | |
| Accounts receivable | $ 15,000 |
| Marketable securities | $ 5,000 |
| Cash and cash equivalents | $ 5,000 |
| Inventory | $100,000 |
| Prepaid expenses | $ 2,200 |
| Total current assets | $ 127,200 |
| Current liabilities | |
| Accounts payable | $ 25,000 |
| Accrued expenses | $ 10,000 |
| Other short-term liabilities | $ 2,500 |
| Total current liabilities | $ 37,500 |
Company B’s total current assets include inventory and prepaid expenses, which are notpartof the quick ratio. However, the quick assets are separately identified, so we can calculatethe quick ratio using the extended formula:
Quick ratio =
(cash & cashequivalents + marketable securities + accounts receivable) / current liabilities
= (15,000 + 5,000 + 5,000)/37,500
= 25,000/37,500
= 0.67
So which company is in a better position to receive funding to cover its short-termobligations?
Why Is Quick Ratio Important?
The quick ratio is widely used by lenders and investors to gauge whether a company is a goodbet for financing or investment. Potential creditors want to know whether they will gettheir money back if a business runs into problems, and investors want to ensure a firm canweather financial storms.
The quick ratio is an important measure of the company’s ability to meet its short-termobligations if cash flow becomes an issue.
What Is a Good Quick Ratio?
A quick ratio that is equal to or greater than 1 means the company has enough liquid assetsto meet its short-term obligations.
However, an extremely high quick ratio isn’t necessarily a good sign, since it mayindicatethe company is sitting on a significant amount of capital that could be better invested toexpand the business.
The optimal quick ratio for a business depends on a number of factors, including the natureof the industry, the markets in which it operates, its age and its creditworthiness. Forexample, an established business with strong supplier relationships and a good credithistory may be able to operate with a significantly lower quick ratio than a startup becauseit’s more likely to obtain additional financing at low interest rates and/or negotiatecredit extensions with suppliers in the event of an emergency.
What Does a Quick Ratio Under 1 Mean?
If a business’s quick ratio is less than 1, it means it doesn’t have enough quickassets tomeet all its short-term obligations. If it suffers an interruption, it may find it difficultto raise the cash to pay its creditors.
In addition, the business could have to pay high interest rates if it needs to borrow money.
How Do Client Payments Affect a Business’s Quick Ratio?
The quick ratio includes payments owed by clients under credit agreements (accountsreceivable). But it doesn’t tell us when client payments are due, which can make thequickratio misleading as a measure of business risk.
For example, suppose Company A has current liabilities of $15,000 and quick assets comprising$1,000 cash and $19,000 of accounts receivable, with customer payment terms of 90 days. Itsquick ratio is 1.33, which looks rather good.
But suppose it has a supplier payment of $5,000 falling due in 10 days. Unless a large numberof its customers pay what they owe within 10 days, the company won’t have enough cashavailable to meet its obligation to the supplier — despite its apparently good quickratio.It may have to look at other ways to handle the situation, such as tapping a credit line forthe funds to pay the supplier or paying late and incurring a late fee.
Now consider Company B, which has current liabilities of $15,000 and quick assets comprising$10,000 cash and $4,000 of accounts receivable, with customer payment terms of 30 days. Itsquick ratio is 0.93, so it looks a lot weaker than Company A.
Company B, too, has a $5,000 supplier payment falling due in 10 days. But unlike the firstcompany, it has enough cash to meet that supplier payment comfortably — despite itslowerquick ratio.
All told, client payments and supplier terms both affect a company’s ability to meetit*short-term obligations. However, the quick ratio doesn’t factor in these paymentterms, soit may overstate or understate a company’s real liquidity position. In addition, thequickratio doesn’t take into account a company’s credit facilities, which cansignificantlyaffect its liquidity.
Advantages and Disadvantages of the Quick Ratio
There are a number of advantages to using the quick ratio:
- During hard times, a business’s ability to leverage its cash and other short-termassetscan be key to survival. Too often, businesses facing cash flow problems have to sell inventory at aheavy discount or borrow at very high interest rates to meet immediateobligations.
- The quick ratio is a useful indicator of a company’s ability to manage cash flowproblems without resorting to fire sales or borrowing money.
However, the quick ratio has several significant disadvantages.
- The quick ratio ignores supplier and customer credit terms. This can give a misleadingimpression of asset liquidity.
- The quick ratio doesn’t tell you anything about operating cash flows, whichcompaniesgenerally use to pay their bills.
- For companies that can sell inventory fast, the quick ratio can be a misleadingrepresentation of liquidity. For these companies, the current ratio — whichincludesinventory — may be a better measure of liquidity.
Working Capital May Be a Lifeline
Need cash fast? Working-capital financing companies may acquire some or all of acompany’s accounts receivable or issue loans using the accounts receivable ascollateral. There are two main models.
Accounts receivable loans:
With customer invoices as collateral, the lender gives the borrower cash or a line ofcredit, normally 70% to 90% of the value of the accounts receivable.
The borrower pays interest on the amount loaned. The rate depends on the lender andother factors and can vary widely, from 5% to 20%.
The credit standing of the end customer, in addition to the financial stability ofthe borrowing company, may affect the rate.
The borrower collects payments from customers directly and uses that cash to repaythe loan.
Invoice factoring:
Differs from an accounts receivable loan in that a company sells its receivableinvoices to another company (called a factor) outright.
Companies can expect between 70% and 85% of the value of the invoices but may need topay fees that cut into that amount.
The factor then collects the invoiced amounts directly from your customers, whichremoves the need to chase and process payments but may have a negative effect onrelationships.
Limitations of Quick Ratio
The main limitation of the quick ratio is that it assumes a company will meet its obligationsusing its quick assets. But generally speaking, companies aim to meet their obligations fromoperating cash flow, not by using their assets. The quick ratio doesn’t reflect acompany’sability to meet obligations from its operating cash flows; it only measures thecompany’sability to survive a cash crunch.
Another limitation of the quick ratio is that it doesn’t consider other factors thataffect acompany’s liquidity, such as payment terms and existing credit facilities. As aresult, thequick ratio does not provide a complete picture of liquidity. Experts recommend using it inconjunction with other metrics, such as the cash ratio and the current ratio.
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How Your Company Can Use the Quick Ratio
In business, cash flow is king and the accounts receivable gap isreal. The ability to rapidly convert assets to cash can be pivotal to help thecompany survive a crisis. The quick ratio provides insight into your company’s abilitytosell assets if needed.
Maintaining an optimal quick ratio may also help you get favorable interest rates if you needa loan, and it can make your company more attractive to investors.
If your company’s quick ratio is below the average for your industry and market, youcanimprove it in a number of ways. For example, you could increase quick assets by cuttingoperating expenses, or you could reduce current liabilities by refinancing short-term loanswith longer-term debt or negotiating better prices with suppliers.
If your company’s quick ratio is significantly above average, it suggests that youmight beable to make better use of your cash by using it to fund business expansion, perhaps byincreasing investments in plants or machinery, hiring more staff or acquiring anothercompany.
To figure out the best way forward, companies often consult with managerial accountants whohave experience analyzing business costs and operational metrics and using that insight toassist executives in the decision-making process.
Free Quick Ratio Template
To calculate your company’s quick ratio, download this free template.
Get the template
While the quick ratio yields insights into a company’s ability to pay its short-termfinancial obligations and is often used by creditors and investors to help decide whether abusiness is a good bet for a loan or investment, it’s not a perfect indicator. Werecommendusing it in conjunction with other business metrics.
Accounting software helps a company better determine its liquidity position by automating keyfunctionality that helps monitor your business’s financial health. NetSuite Financial Management automates moreaccounting processes and gives you and your finance team easy access to data for analysis–with high impact functions to automate including invoicing, financial report generation,data collection and document storage, and compliance.
