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What is Quick Ratio and How to Calculate: Meaning, Formula, and Example
Sometimes well-run businesses may face unexpected issues regarding cash flow that necessitate the sale of assets to pay for expenses — since revenue is hardly constant month after month, and sometimes disasters crop up. But, as a business owner or investor, how do you determine how selling assets, such as accounts receivable or securities, will impact your financial situation? The quick ratio is one method for assessing a business's capability to quickly transform short-term assets into funds.
Let's take an in-depth look at the quick ratio meaning.
What Is Quick Ratio?
The quick ratio, aka the acid-test ratio, compares a company's short-term liquidity to its short-term liabilities. Essentially, the quick ratio seeks to determine whether a business has enough liquid assets (assets that could be quickly turned into cash) to cover its forthcoming debts and current liabilities. However, it is essential to note that this is not a test to determine how much debt a company has or whether it could seek funding to cover any current debts. The quick ratio simply examines whether a business's liquid assets outmatch its liabilities.
This ratio is significant because it provides an overview of a company's financial health: Is it utilizing its assets to avoid incurring additional debt?
In a crisis, a business with a negative (less than 1) quick ratio is expected to fail, while a business with a positive (more than 1) quick ratio is expected to survive.
Quick Ratio vs. Current Ratio
The current and quick ratios are the two most common ratios used to assess a business's financial health. Both ratios work by comparing a business's assets and liabilities.
However, the current ratio includes prepaid expenses and inventory in assets because assets for the current ratio can be described as anything that can be liquidated within a year. On the other hand, the quick ratio focuses on very short-term, highly liquid assets, leaving out prepaid expenses and inventory.
Each ratio is evaluated slightly differently, too. For instance, the current ratio is excellent at producing high ratio scores for businesses with extensive inventories. In contrast, the quick ratio is more conservative, particularly for inventory-reliant business models.
Quick Ratio Components
A business's liquid assets are cash or comparable to cash; this includes cash and savings, accounts receivable (money owed to the company by clients and customers), and marketable securities (bonds and stocks).
Current liabilities would be any immediate debts owed by a business. Accounts payable (money owed by the company to clients or other companies), employee salaries, taxes, and expenses toward long-term debts (like loans) are all included.
Quick Ratio Formula
The quick ratio of a company is calculated by dividing its most liquid assets, as well as current assets, by its total current liabilities. The formula is as follows:
Liquid Assets / Current Liabilities = Quick Ratio.
Quick Ratio Example
Let's assume a business has the following:
Cash and equivalents: $23,646 million
Inventories: $4,946 million
Accounts receivable: $28,184 million
Marketable securities: $24,658 million
Other current assets: $53,971 million
Term debt: $11,128 million
Accounts payable: $64,115 million
Other liabilities: $78,739 million
So, we must calculate the company's liquid assets, which are current assets minus the inventory and prepaid expenses. The company's liquid assets total $130,459 million for the financial year 2022. The current liabilities of the company total $153,982 million. As a result, our formula would be:
$130,459m (liquid assets) / $153,982m (current liabilities) = Quick Ratio
Based on this formula, the company's quick ratio for 2022 is: 0.85
Importance Of Quick Ratio
Quick ratio reveals a plethora of information about a business's financial situation. It compares the value of the business's liquid assets to its liabilities. It could include anything, such as debts and other obligations, that has to be paid in full within twelve months. Such obligations can be easily discharged with liquid assets held by the company.
A quick ratio accurately indicates a business' ability to discharge its obligations and debts. A healthy liquidity ratio demonstrates the business's competence and ensures stellar business performance. An investor or analyst can utilize the ratio to determine whether a company has enough liquid assets to cover its short-term liabilities.
Pros And Cons Of Quick Ratio
There are several benefits of using a quick ratio:
- During difficult times, a company's capacity to utilize its cash or other (short-term) assets can be critical to survival. Businesses experiencing cash flow issues often are forced to sell their inventory at deep discounts or borrow at exorbitant interest rates to meet current obligations.
- The quick ratio is an important marker of a business's capacity to manage cash flow issues without having to resort to borrowing money.
The quick ratio also has several drawbacks.
- Quick ratio disregards credit terms with suppliers and customers; this can create a false impression regarding asset liquidity.
- A quick ratio says nothing about operational cash flows, which are used by businesses to pay the bills.
- For businesses that can sell inventory quickly, the quick ratio can be an inaccurate representation of liquidity.
Quick Ratio's Limitation
The fundamental flaw of the quick ratio is that it assumes a company will fulfill its obligations through its current assets. Businesses generally try to fulfill their obligations with operating cash flow instead of current assets. The calculation doesn't consider a business's ability to meet obligations through operating cash flows. It solely assesses a business's ability to withstand a liquidity constraint.
Another limitation of the quick ratio is that it tends to ignore other aspects of a business's liquidity, like payment terms, bargaining power, and existing credit terms. Thus, the quick ratio does not provide a comprehensive picture of liquidity. Combining it with other ratios/metrics like the current and cash ratios is recommended.
Calculating the quick ratio is simple if you have a business's balance sheet. You can put the values into the formula to calculate the Quick ratio in seconds. It is a widely used metric for evaluating a business's financial health.