Knowing the current financial health of your business is essential for making good short-term decisions, and one of the short-term liquidity measurements used is the quick ratio. In short, the quick ratio is related to the cash amounts a company has in its possession for managing its short-term obligations without the need to sell inventory quickly or get additional funds. Well, it is more than this, and we’ll talk about the quick ratio in more detail here.
What Is Quick Ratio?
The financial definition of the quick ratio is as follows: the quick ratio is a financial indicator of short-term liquidity or an indicator of the ability of a company to raise cash to pay its short-term obligations. As a result, the quick ratio is a vital calculation for new businesses and established businesses.
A more colloquial term for the quick ratio is the acid test ratio, as it points to the instant results this financial indicator shows. First, let’s clarify the definition of quick ratio, as it measures the cash amount of available liquid assets for paying the current liabilities.
When we say liquid assets, we mean all the current assets that can be swiftly converted into cash without significant loss of value. The current liabilities are the company’s debts and obligations due to be paid in the short term, usually within 90 days.
It is called the quick ratio, as it measures only the liquid assets of a company or the assets that can be quickly converted into cash. It differs from the current ratio, but we’ll address this in more detail below.
Calculating Quick Ratio
Now that you know how the quick ratio is defined, we need to talk about how you can calculate it. The quick ratio formula is simple: take the amount of liquid assets and divide it with the current liabilities, and you’ll get the quick ratio.
Here is the general quick ratio formula:
QR – Quick Ratio
LA – Liquid Assets
CL – Current Liabilities
However, there are other ways this formula can be expressed. It is most suited for businesses that have cash equivalents and marketable securities that can be sold very quickly, like the following:
QR – Quick Ratio
CE – Cash and Cash Equivalents
MS – Marketable Securities
AR – Accounts Receivables
CL – Current Liabilities
And another way of calculating the quick ratio, where the business deals with inventory subjected to a quick turnaround:
QR – Quick Ratio
CA – Current Assets
I – Inventory
PE – Prepaid Expenses
CL – Current Liabilities
The quick ratio or acid-test ratio is a number that shows the ability of a company to pay its current liabilities. From the quick ratio formula, you can see that the expected number can be smaller or bigger than 1.
For example, if the quick ratio is 1, it shows that the company possesses the exact amount of liquid assets to pay its current liabilities. Conversely, if the quick ratio result is less than 1, the company does not have enough liquid assets to pay its current liabilities. In some cases where the quick ratio is very low, the company may need short-term financing to pay the immediate obligations.
Consequently, if the quick ratio is greater than 1, the company can instantly pay its current liabilities. Still, a high quick ratio is not good either, as it points that the company has a lot of extra cash lying around that could be used for investments and improving the business.
Understanding the Quick Ratio Formula
All the components for calculating the quick ratio can be found on the company’s balance sheet. Be sure to use the correct components so that you can get the correct quick ratio result.
Under current assets, we need to note that you should use only the assets that can be very quickly converted into cash, usually within 90 days or less, but without significantly lowering their price. It usually does not include inventory (raw materials, components, finished products), as a company would have to discount the price significantly to stimulate quick purchases.
Suppose you are using the more detailed quick ratio formula. In that case, you need to note that you should only consider the accounts receivable (money that is owed to the company for delivered goods or services) that can be collected within about 90 days or less.
Here we come to the importance of the accounts receivable, as these can significantly impact the quick ratio and the company’s ability to pay off its current liabilities. For example, suppose a company negotiates a faster payment from clients and secures longer payment terms to suppliers. In that case, it will have a healthier quick ratio and be better equipped to handle current liabilities.
Quick Ratio Example
We’ve prepared a simplified example to show how the quick ratio is calculated and applied. A small bakery is looking to get a remodel loan, and the bank needs to see its quick ratio to estimate the potential risks. Due to the nature of the bakery’s business, the bank gets the following accounts from the bakery’s balance sheets:
- Liquid cash - $15,000
- Accounts receivable - $3,000
- Inventory - $4,000
- Stock Investments - $1,500
- Prepaid taxes - $1,000
- Current Liabilities - $15,000
The amount of current assets is calculated as the sum of the liquid cash, accounts receivable, and stock investments, minus the inventory and prepaid taxes; in this case, the current assets are $14,500. Thus, when divided with the current liabilities amount or $15,000, the quick ratio is:
QR = 0.96
It means that our bakery has 0.96 cents available for paying every dollar of current liabilities. It is up to the bank to decide if they will back up this business with a loan, as other factors are at play.
Why is Quick Ratio Important?
By calculating the company’s quick ratio, you get insight into the company’s current financial situation. In addition, this measurement is valuable for companies looking for additional financing, as investors and creditors want to see the immediate financial stability of the company before granting it funds.
As with all the other financial ratios, the quick ratio should be calculated regularly. It will help you keep an eye on your current financial state. For example, if you determine that your quick ratio is going down, you can take the necessary steps and improve your financial situation. These measures may include improving the ability to collect on the accounts receivable or improve marketable securities.
Factors That Affect Quick Ratio
Here is an outline of the factors that affect the quick ratio. Understanding these factors can help you better manage your company and improve the quick ratio, thus improving its current financial situation.
- Inventory Turnover – the higher inventory turnover (meaning higher sales) means that even if you don’t take the entire inventory into account when calculating the quick ratio, it can still positively affect the quick ratio. Faster sales mean more cash influx, which translates into a better quick ratio.
- Collecting on accounts receivable – arranging faster payments from clients has a positive impact on the quick ratio. As a rule of thumb, allowing 30 days for customer payments will put a company in a better financial position than a company that allows 90 days for customer payments.
- Paying Off Liabilities – the sooner the current liabilities are paid, the lesser the formula divisor will be; thus, the company will have a better quick ratio
Quick Ratio vs. Current Ratio
As promised, we’ll also talk about the differences between a company’s quick ratio and current ratio. Both of these are financial ratios and serve to showcase the financial health of a company. Both are calculated by dividing the current assets by the current liabilities. However, they differ slightly, mainly in the factors that enter the calculation.
As we outlined above, the quick ratio measures a company’s liquidity by dividing the current assets by the current liabilities. The quick ratio, also known as the acid-test ratio, is more of a short-term financial measurement, as it includes assets that can be converted into cash within 90 days or less.
On the other hand, the current ratio measures the company’s ability to pay current liabilities but includes current assets like cash or cash equivalents converted into cash within one year. The current liabilities are the debts and obligations of a company due within one year.
Now that you know the essentials of this crucial financial calculation, you can focus your efforts on improving your company’s quick ratio and getting a better chance of securing a loan and improving your company’s standing.