Quick Ratio: Definition & Interpretation



What is the Quick Ratio?

The quick ratio is also known as 'acid test' ratio that measures the liquidity of the company at the immediate level, that is, if a company has to pay its liability out rightly, without having time to wait for the scale - of - trade. 

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

Quick assets are those assets which are converted into cash within 90 days, such as cash, account receivables, short term loans etc.


                 

Quick Ratio Formula

Quick ratio can be calculated as follows,
        
Quick Ratio=(Cash + short term investments + accounts receivable + short term loans & advances)/Current Liabilities


Alternative quick ratio formula is,
        Quick Ratio=(Current Assets - Inventory - prepaid Expenses)/Current Liabilities


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

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

Inventory includes raw materials, work in progress and finished goods.


Quick Ratio Example

             


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

Balance sheet of ABC company as on 31.03.2019
                  

    Now, Quick Ratio=(6,20,000 - 2,50,000 - 1,00,000)/1,55,000
                                      =1.74 times

It means that ABC company could pay off their current debt obligations with quick assets and still have some quick assets remaining. This company reflects high liquidity.
           (We have taken last formula)



Quick Ratio Interpretation

The acid test ratio shows how well a company can meet its short term debt obligations. This ratio is applied to judge the short term liquidity. A higher ratio is better than lower ratio.
     
A higher quick ratio (more than 1) indicates that a company can convert its assets into cash very quickly without need to liquidate its longs terms assets. So, a company can easily repay its short term debt obligations.
      
A lower quick ratio (less than 1) is a caution about the liquidity of the company. A low ratio does not indicate a good sign regarding repayment of the short term debt obligations. 
       

What is a good quick ratio?

As a rule of thumb, quick ratio ideally be more than 1, but a very higher ratio (quick ratio more than 2.5) indicates the company is not able to manage its cash properly and a considerable amount is lying ideal which is not generating any return.
       
At times, the quick ratio doesn't give true measurement of liquidity of the company. So, the formula assumes that a company could liquidate its current assets to pay off current liabilities.

 But you need some level of working capital to operate the business. Another limitation of the quick ratio is that it provides no information about the level or timing of cash flows and these are very important to determines a company's ability to pay liabilities when due.
      
Usually, investors and analysts prefer high ratio. So, as a smart investors, quick ratio should be compared with the industry average and find out a trend of past few years.


Why doesn't take inventory & prepaid expenses in quick assets?

Inventory and prepaid expenses are current assets but aren't quick assets. Because, inventory takes a long time to be converted into cash and prepaid expenses can not be used to pay current liabilities.


Current Ratio vs Quick Ratio

Quick ratio is more conservative ratio than other ratio such as current ratio because inventory and prepaid expenses are not considered in quick ratio because inventory takes a long time to be converted into cash. 

The quick ratio considers those assets which are converted into cash within 90 day or very quickly. It is important to note, few companies inventory are considered a quick assets.

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