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
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.