quick ratio explained for complete beginners by zerobizz

The Quick Ratio is considered to be one of the most liquid ratios in the current ratio. The Quick Ratio measures the ability of a company to pay down for current liabilities and short term expenses.

What is Quick Ratio?

The quick ratio is an indicator of the short term liquidity position of a company and measures a company's ability to pay its short term liabilities with the most liquid assets. 

Its ratio establishes a relationship between the current liabilities of the company and its quick assets. 

The quick ratio also indicates how instantly a company can utilise its short term assets ( assets that can be transformed quickly to cash) to pay off short term liabilities. Therefore, the quick ratio is also known as the acid test ratio as well. 

Quick Ratio Formula

The quick ratio can be calculated in two ways following:

Quick ratio Formula 1:

Quick Ratio = (cash + accounts receivable + marketable securities) / current liabilities

Quick Ratio Formula 2:

Quick ratio = (current Assets - inventory - prepaid Expenses) / current Liabilities

Where current assets are held for less than one year and can be converted into cash. Current assets are also termed liquid assets. Such as cash, stock term investments etc.

Current liabilities are also called short term liabilities. These obligations have to be settled within one year. Such as creditors, bank overdraft etc.

Is inventory a quick asset?

Inventory is a current asset but is not a quick asset, because inventory takes a long time to be converted into cash. 

Inventory cannot be converted into cash as quickly as accounts receivable or marketable securities. 

A prepaid expense is not also a quick asset because prepaid expenses can not be used to pay current liabilities.

How to calculate the quick ratio?

The calculated quick ratio through the step by step process following:

1st step:

The most important step in the process is looking at a company's balance sheet and will take all the numbers from the balance sheet such as cash, accounts receivable, marketable securities and current liabilities calculate the quick ratio.

2nd step:

Add all of these assets which have been found from the balance sheet to the numerator for current liabilities as of the denominator and Divide to find the quick ratio.

Or, simply use the current assets and subtract inventory and prepaid expenses which have been found from the balance sheet to the numerator and then use the number on the balance sheet for the current liability as to the denominator. 

Divide to find the quick ratio.

Quick Ratio Example

Let, it is ABC company. Here is some information about the ABC company.

The balance sheet of ABC company as on 31.03.2019


Particular Amount (Rs.)
Non-current assets
Fixed assets 425,000
Long term investments 390,000
Total non-current assets 815,000
Current assets
Cash in hand 20,000
Bills receivable 50,000
Inventory 250,000
Prepaid expenses 100,000
Short term loans 200,000
Total current assets 620,000
Total assets 14,35,000
Equity
Share capital 600,000
Reserve 330,000
Total equity 930,000
Non-current liabilities
Debentures 200,000
Long-term loans 150,000
Total non-current liabilities 350,000
Current liabilities
Bills payable 50,000
Overdraft 100,000
Short-term loans 5,000
Total current liabilities 155,000
Total equity and liabilities 14,35,000

Quick Ratio = (6,20,000 - 2,50,000 - 1,00,000) / 1,55,000

Quick Ratio = 2,70,000 / 1,55,000

Quick Ratio = 1.74 times

The quick ratio of the ABC company is 1.74 which indicates that ABC company could pay off their current debts and obligations with quick assets and still have some quick assets remaining. This company reflects high liquidity.

(Here, we have taken the last formula.)

Current Ratio vs Quick Ratio

The quick ratio and current ratio both are considered liquidity ratio that indicates the capability to pay off its current liabilities. The quick ratio is considered more conservative than the current ratio. 

The current assets include all the current assets but the case of quick ratio includes quick assets which convert into cash within 90 days such as, cash & cash equivalents, deposits, etc.

There are differences between the current ratio and the quick ratio following:

1. The current ratio is the efficiency to pay the company's short-term obligations whereas the quick ratio is the ability to pay the company's current liabilities. 

2. The ideal current ratio is 2:1 on the contrary the ideal quick ratio is 1:1. 

3. The current ratio is the proportion between current assets and current liabilities whereas the quick ratio is the proportion between quick assets and current liabilities.

Quick Ratio Interpretation

The quick ratio shows how well a company can meet its short term obligations. This ratio is applied to judge the short term liquidity. 

The quick ratio examines a dollar amount to a company's liquid assets ready to coat each amount of its current liabilities. A company's current liabilities are debts and obligations that must be paid down within one year.

A decent liquidity ratio is accepted as the efficiency of the organization and ensures the convincingness of strong business which can ultimately lead to the endurable progress of an organisation. A higher ratio is better than a lower ratio.

A higher quick ratio (more than 1) indicates that a company can convert its assets into cash very quickly without needing to liquidate its long term assets. So, a company can effortlessly pay back its short term obligations.

A lower quick ratio (less than 1) is a warning about the liquidity of the company. A low ratio does not indicate a good indication regarding repayment of the short term obligations and the company is sure of heavily on inventory and may be sorely requiring additional liquid assets.

At times, the quick ratio doesn't provide a valid measurement of the liquidity of the company. The formula assumes that a company could liquidate its current assets to pay off current liabilities.

However, you need some level of working capital to operate the business. Another limitation of the quick ratio is that it provides no data about the level or timing of cash flows and these are very significant to infer a company's ability to pay liabilities when due.

What is a good quick ratio?

The quick ratio measures the ability of a company to pay its outstanding obligations when coming due and a good quick ratio is 1 or more than 1, the greater number indicates enough liquid assets a company has to pay off its short term debts.

A quick ratio less than 1 indicates that an organization does not have sufficient liquid assets to pay off its current liabilities. Usually, investors and analysts prefer a high ratio. 

As a smart investor, the quick ratio should be compared with the industry average and find out a trend of the past few years.

Limitations of the quick ratio

The quick ratio has also specific limitations and investors should be aware of that. Here are the  limitations of the quick ratio following:

1. The ratio omits inventory from the calculation, which may not be reasonable for companies where inventory can be easily valued at a marketable price. 

If the ratio relies solely on cash or cash equivalents, the exactness of the outcomes will be lacking.

2. The ratio may not be suitable for all types of business models for demonstrating short term solvency because if companies with higher inventory, like supermarkets remove inventory to reach a liquidity situation, it may not be virtually accurate to do so.

3. Quick ratio enables the company to predict the future, but it is also evaluated in the data of the past, which can lead to such estimates being false. For example, an organization may have a less quick ratio. 

4. The ratio considered account receivables are a liquid asset and can be easily converted into cash which may not always be the case.

FAQs

1. what are quick assets?

Quick assets are those assets that are converted into cash within 90 days. Quick assets include cash, marketable securities and account receivables.

2. what is the formula for quick assets?

Quick assets include such assets which may be converted into cash with a slight effect on its price in the open market.

Quick assets formula:

There are two ways to calculate quick assets -

Quick Assets = current assets - inventory - prepaid expenses

Or, quick assets = Cash + marketable securities + account receivables

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