Quick Ratio is one of the Liquidity Ratios used to measure the company’s liquidity position, project, investment center, or profit center. 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 included in the calculation because 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, the entity’s current assets after the deduction of inventories are 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 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,
- 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 a long time to convert into cash to pay current liabilities. For example, to convert the inventories into cash, we need to sell that inventories to customers and collect cashback.
Some customers purchase on credit in the collection process and keep a bit longer to make payments 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. The 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 with 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.
ABC Company has the following transaction in its Financial Statements for the period ended 1 January 2016 to 31 December 2016.
- Cash = $100,000,
- Advance = $10,000,
- Marketable Security = $50,000,
- Account Receivable = $60,000,
- Inventories = $70,000.
- Total Current Assets = $290,000
- 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.
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 a period shorter than 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.
The main reason 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. In calculating the 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 asset takes a 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 depends 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. Eliminating it from its ratio could help management, share investors, shareholders, and other stakeholders have accurate information to assess its liquidity position.
- Another advantage of the quick ratio is that this ratio is straightforward to understand and straightforward. It can help the users of ratio who don’t have great skill in accounting and finance to understand this ratio easily. For example, some of the operation managers whose KPI are including the quick ratio could see and understand how the ratio works and the massages that the ratio is telling.
- This ratio is measured as 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 sizes of the entity. This ratio compares current assets and current liabilities, and the results measure as percentages. That means we can compare it to the other entity or competitors which have different sizes and nature.
Disadvantages of Quick Ratio:
Although the quick ratio has some advantages, it also has certain disadvantages that the users, especially the specialist responsible for the analyst and interprets this ratio, should be aware of. Here are those disadvantages of quick ratio:
- It is a financial indicator. As we know, this ratio uses financial information to analyst the liquidity position of the entity. The management of the entity could influence this financial information 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 assesses 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, the management team has a very credit and relationship with the banks or 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 on 31 December 2016. Based on the explanation above, the entity has an excellent ratio. But what if the entity requires to pay off the high amount of loan in the month 13th. From the accounting perspective, this 13 months loan treat as long-term liabilities as of 31 December 2016. But in 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.
- 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
Written by Sinra