How to improve quick ratio?

Quick Ratio:

Quick ratio can best the best determinant of liquidity measures within a company. As a matter of fact, it can be seen as a measure to validate the organization’s ability to meet its day to day expenses and other short-term liabilities like accounts payable and accrued interest expenses.

In this article, we will discuss the ways how a company could use to improve the quick ratio when the calculation shows that ratio performance is not meet the expectation of company management.

Formula:

The quick ratio or acid-test ratio can be calculated through the following formula:

(Current assets – inventory) / Current Liabilities

How to improve quick ratio?

Often the greatest organizations are faced with the greatest challenges pertaining to liquidity, to an extent where they are often forced to shut down.

Therefore, given the overall importance of ensuring liquidity within the firm, it is really rudimentary for organizations, regardless of their size to ensure that they follow certain protocols to improve their quick ratio.

  1. Increasing Sales and Inventory Turnover: There is no doubt to the fact that Sales and Inventory Turnover are some of the greatest determinants to gauge business standing. However, in order to improve the liquid resources your business has in hand, it gets pivotal to increase the sales for your company. In return, this will increase inventory turnover. Having greater turnover means greater cash in hand for the company, and hence, greater sales.
  2. Improving Invoice Collection Period: Long-term Debts extended to clients are often one of the biggest reason for a company’s inability to meet its expenses. As a result, it often gets challenging to manage cash, and despite the fact that one might have greater sales and assets (long-term debtors), the liquidity position might get gruesome. It also increases the company’s exposure towards risk, because of the chance of clients defaulting on those debt gets higher, and significantly increases the probability of increased bad debts for the company. Therefore, by giving long-debtors discounts in order to attract them to pay early, your organization can quickly convert long term assets into cash, thereby increasing the liquidity you have at your disposal.
  3. Paying off liabilities quickly: Current liabilities tend to have an inverse relationship with quick ratio, which should, therefore, be decreased. This can be achieved by ensuring that you are able to pay back liabilities in due time.
  4. Discarding unproductive assets: Often in an organization, the corporation has certain assets lined up which do not generate any considerable revenue for the company. These assets need to be identified and then discarded in order to get cash against those assets. This cash can then be taken for short term liquidity of the company, hence improving the quick ratio of the company.
  5. Drawings: As far as drawings are concerned, it can be seen that drawings from business owners should also be prioritized and kept at a minimum. If your business is a partnership, then there should be strict preventions to ensure that there are no withdrawals in the form of drawings, because that just takes a heavy toll on the existing cash in the company.

Conclusion:

In addition to the features listed above, it can further be stated that the best manner to ensure that your company has an improved quick ratio is to ensure that there are strategies and plans decided which can ensure that there are sufficient funds and paybacks to facilitate the working capital of the business.

By investing less in inventory (adopting policies like Just in Time), you can ensure that you do not have a lot of money tied up in inventory.

Similarly, by ensuring that you are able to keep your credit limits in check for long term debtors, your business can have sufficient cash on hand to be able to manage the day to day expenses in a viable manner.

It is absolutely crucial that one does a holistic analysis of the Current Assets and Liabilities for the company so that it is easy to analyze which aspect needs to be highlighted and taken care of.

Importance and limitations of quick ratio

Overview:

The quick ratio is a financial ratio used to measure the short-term liquidity of a company where liquidity is defined as the ability of a firm to convert its most liquid assets into cash so that it could settle its current liabilities.

The quick ratio, also known as acid test ratio, measures how quickly a company can pay off its short-term debts and obligations through its near-cash (current) assets.

It is calculated by dividing current assets excluding stock-in-hand by current liabilities as shown below:

Here is the formula:

Quick ratio = (Cash& cash equivalent + Marketable security + Accounts receivable) / Current Liabilities

OR

Quick ratio = (Current assets – Inventory – Prepaid expenses) / Current liabilities

An acid test ratio is a more aggressive method of measuring liquidity as compared to the standard current ratio. The difference between both is inventory and prepaid expenses which may take some time to turn into cash and may also have a reduction in value.

For example, to convert inventories into cash, the company need to cash those inventories to customers. Not all of the sales are through cash in most of the business. The majority of them are sales on credit and the company does need more time to collect the payment.

The current ratio includes all the current assets that can be converted to cash within a year whereas quick ratio includes current assets that can be converted to cash in 90 days only i.e. 3 months.

An optimal quick ratio is considered as 1:1 i.e. current liabilities = current assets. The ratio calculates every dollar of current assets available to pay off a dollar of current liability.

For example, if a current ratio of a company is 2:1, it means that it has $2 available to pay off every $1 liability. Similarly, a ratio of less than 1:1 signifies that the company doesn’t have enough liquid assets to pay off its short-term obligations.

In this article, we will discuss the key importance and limitation of quick ratio when it comes to the assessment of the liquidity of the entity:

Importance of quick ratio:

  • The quick ratio is one of the fastest and easiest ways of measuring a company’s liquidity. It is majorly used by creditors and lenders to evaluate an entity’s creditworthiness and timely payments before approving their application for the loan. Financial information to be used for calculation is easily obtained from financial statements.
  • The quick ratio is an inflexible method of demonstrating the liquidity of a company. It excludes assets like inventory and prepaid expenses that take more than a year to turn into cash and may lose value as well during the time period. For example, a company that has inventory piled up due to low sales may have a high current ratio which would portray it as a liquid company even if it is running low on cash due to lower sales. Quick ratio ensures no such misleading information is portrayed regarding the liquidity of an entity.
  • A quick ratio around the ideal value of 1:1 also signifies that the company is able to pay dividends on time which is considered a major pro since everyone wants money on time. Potential investors consider the quick ratio to make decisions about investing in the entity or not.
  • A high quick ratio also implies that businesses are well prepared to adapt to any changes in business environments that attract investors as well.
  • Measuring inventory involves judgment of management making it susceptible to human error. Quick ratio excludes inventory and hence, is a more precise unit of measure as compared to the current ratio.

Limitations of the quick ratio:

  • One of the major cons of the quick ratio is that it can’t be used to compare various industries and can only be a metric of comparison for similar companies. A quick ratio is a mathematical value that provides no context of the assets and liabilities calculated.
  • It doesn’t take into consideration the time frame of payments. For example, some of the accounts receivables included in current assets may become bad debts that will never be recovered in the future or may include receivable recovered after more than a year which actually has a negative impact on the liquidity of the company whereas the quick ratio portrays otherwise. Even the ratio is more than one but there is a high proportion of inventories compare to current assets that use for calculating the ratio then the decision that made based on this ratio is highly likely to be wrong.
  • Where excluding inventory may be a pro it can also be a con for industries that have higher inventories. For example, a supermarket purchases millions of dollars of inventory by credit or by using cash and cash equivalents. In this case, the current liability balance would increase due to inventory purchased on credit and cash balance would be low which would cause a reduction in current assets resulting in an extremely low quick ratio. In such a case, justification should be made whether the inventories should be included or not.

Quick Ratio: Definition | Formula | Example | Analysis | Advantages | Limitation

Definition:

Quick Ratio is one of the Liquidity Ratios that use to measure the liquidity position of the company, project, investment centre or profit centre.

The special characteristic of this ratio from the other Liquidity Ratios is that Quick Ratio taking account only cash and cash equivalent items for calculation and interpretation.

It disregards other items which might not quickly convert into cash easily from the calculation.

For example, inventories are not including in the calculation on the basis that they are taking a very long time to convert into cash. This ratio is sometimes called Acid Test Ratio yet the meaning is still the same.

If the ratio is higher than one, that means the entity’s current assets after the deduction of inventories is higher than current liabilities. This subsequently means the entity could use its current assets to pay off current liabilities.

Or we can say that the entity is a financial healthy base on this ratio tells us.

The same as if the ratio is lower than one, the entity might not be able to pay off its current liabilities by using its current assets. We can say that the entity is not financially healthy.

See the ratio interpretation and analysis below.

The Formula of Quick Ratio

The formula for this ratio is quite simple,

Quick Ratio = (Current Assets – Inventories)/Current Liabilities

  • Current Assets here including Cash, Cash Advance, Receivable, Other Current Assets, Inventories, Marketable Security, or similar. The easiest way to calculate or find the Current Assets is to go to the company’s Financial Statement and then find out the Current Assets balance at the end of the period.
  • Current Liabilities included Account Payable, Accrual Liabilities, Short-Term Debt, Interest Payable, Current Tax Payable or similar. The easiest way to calculate and find Current Liabilities is to go to the Financial Statements and find out the Current Liabilities. It is clearly stated there.

In your calculation, you have to make sure that Inventories are excluded; otherwise, it will be a misinterpretation.

Related: How to Calculate Earnings Per Share?

Why are Inventories disregards (excluding) in Quick Ratio?

The main reason is that the quick ratio measure how quickly the company’s current assets could settle its current liabilities.

Inventories are also the current assets based on their nature and accounting classification. However, inventories need some long time to convert into cash in order to pay current liabilities.

For example, in order to convert the inventories into cash, we need to sell that inventories to customers and collect cashback.

In the collection process, some customers purchase on credit and also keep a bit long time to make payment for the purchased items. Because of these reasons, inventories are excluded.

This is also the main difference between the current ratio and the quick ratio. Current Ratio includes the Inventories in its calculation and measures the liquidity of the company.

This is a big risk and the right assessment is not getting done for the company that has a high amount of Inventories in its Current Assets.

Quick Ratio: Example and Calculation

The following is the example related to the calculation of the quick ratio. Let work together so that you could deeply understand.

Example:

ABC Company has the following transaction in its Financial Statements for the period ended 1 January 2016 to 31 December 2016.

Current Assets:

  • Cash = $100,000,
  • Advance =  $10,000,
  • Marketable Security = $50,000,
  • Account Receivable = $60,000,
  • Inventories = $70,000.
  • Total Current Assets = $290,000

Current Liabilities:

  • Account Payable = $160,000,
  • Accrual Expenses = $60,000,
  • Short-term Debt = $50,000,
  • Interest Payable = $50,000.
  • Total Current Liabilities = $320,000.
  • The previous year Quick Ratio was 1.5 and the industry average for the current year is 1.6.

Evaluate the Quick Ratio of ABC Company.

Answer:

Now a summary of the information that we will use for calculation.

Formula : Quick Ratio = Current Assets – Inventories/Current Liabilities

Current Assets = $290,000

Inventories = $70,000

Current liabilities = $320,000

QR = ($290,000 – $70,000) / $320,000 = 0. 69 or 69%

Quick Ratio Interpretation and Analysis:

Now let see what does Quick Ratio = 0.69 means to ABC Company.

Based on the calculation above, the current year’s quick ratio is 0.69 while the previous was 1.5.

The quick ratio measures how ABC Company’s most Liquid Assets could settle the Current Liabilities which are most likely require to pay in the period shorter that one year.

The Current Year QR is lower than one. This is clearly shown that the company does not has enough Liquid Assets to pay for Current Liabilities.  

This is telling us that ABC potentially has Liquidity problems. Compare to the previous year and industry average, ABC does not manage its  Liquid Assets properly.

This is probably the sale and production performance is not so good. ABC might need to review and assess the current performance of its Sale and Production function.

However, the Quick Ratio is the ratio that measures the short period of time of the liquidity position and it might not mean that ABC has a liquidity problem. Here is the reason.

Let say the main reason why Account Payable is so large is because of the large amount of purchase due to the large order and this is going to be decreased when the company pays to the vendor as the result of large cash collection from credit sale.

Or this is just a short time and the company currently has a good relationship with its banks then this shortfall of cash is not the problem.

Advantages of Quick Ratio:

  • The best advantage of a quick ratio compares to other liquidity ratios especially the current ratio is that this ratio help to measure how well current assets pay off current liabilities more accurately. The calculation of quick ratio, we use only the most liquid assets that could transform into cash quickly or even become cash already. That means this kind of assets takes a very short time to become cash when the current liabilities are required to pay off.
  • As mentioned above, this ratio excludes inventories from its calculation. As we know, inventories could take a long time to convert into cash. It is depending on the types of business and market that the entity operating in. Some inventories take a day to convert into cash, some require months or even more than one year. Eliminate it from its ratio could help management, share investors, shareholders, and other stakeholders to have accurate information to assess the entity’s liquidity position.
  • Another advantage of the quick ratio is that this ratio is very easy to understand and straight forward. It can help the users of ratio who doesn’t have deep skill in accounting and finance to understand this ratio easily. For example, some of the operation managers who their KPI are including quick ratio could see and understand how the ratio works and the massages that the ratio is telling.
  • This ratio is measured as the percentages. So if the ratio is higher than the target, that means some actions are required to fix.
  • Set as KPI and compare it’s with different size of the entity. This ratio compares current assets and current liabilities and the result measure as percentages. That means we can compare it to the other entity or competitors which have different size and nature.

Disadvantages of Quick Ratio:

Although the quick ratio has some advantages, it also has certain disadvantages that the users especially the specialist who is responsible for the analyst and interprets this ratio should be aware of. Here are those disadvantages of quick ratio:

  • It is the financial indicator. As we know this ratio uses the financial information to analyst the liquidity position of the entity. This financial information could be influenced by the management of the entity if they want. Maybe they could influence by accounting policies or fictitious financial information.
  • It uses past data to predict the future. The quick ratio is assessing how the entity could pay off the current liabilities by using current assets now and in the future. This probably not helps users to get their objective more accurately. For example, even though the entity has a poor ratio, but the management team have a very credit and relationship with the banks or even with the suppliers. They might solve this problem better than the entity that has a good ratio.
  • The high ratio does not always good. For example, the entity has a 1.5 quick ratio at 31 December 2016. Based on the explanation above, the entity has a very good ratio. But what if the entity requires to pay off the high amount of loan in the months 13th. From the accounting perspective, this 13 months loan treat as long term liabilities as of 31 December 2016. But in the month of January 2017, that 13 months become current liabilities and subsequently affect the quick ratio just a month after valuation (31 December 2016). So, this ratio might lead the users to make the wrong decision.

Conclusion:

Quick Ratio:

  • Liquidity Ratio measurement
  • Better liquidity measurement than Current Ratio
  • Only Liquid Assets and Liquid Liabilities are included
  • The higher ratio, the better company able to meet its current obligation
  • Lower ratio, higher risk of meeting problem with short term obligation

Reference:

  • www.investopedia.com
  • https://en.wikipedia.org/wiki/Return_on_assets

Written by Sinra