The quick ratio, or the acid-test ratio, is an account that most companies use to determine their liquidity. Since it helps determine whether a business has enough funds to meet its short-term obligations without selling the inventory, it is beneficial in times of uncertainty. By analysing the quick ratio, companies, investors, and creditors can decide whether an organisation possesses sufficient available resources to pay current liabilities. The article discusses precisely what is quick ratio, quick ratio formula, how to calculate quick ratio, why it matters and some possible limitations associated with its application.
What is Quick Ratio?
The quick ratio can be defined as a firm’s ability to pay off short-term liabilities using its more liquid assets. Liquid assets are cash or other assets that will not drop much if converted to cash instantly. It is very important because it eliminates less liquid assets, such as inventory and prepaid expenses, to understand a firm’s liquidity better.
Quick assets of a company typically include the following;
1. Cash and Cash Equivalents: It is regarded as the amount of money that is in the company’s possession with the capability of being used to fund the business activities in the shortest notice this speaks of an amount of cash in hand, at the bank, or of an investment that can quickly be sold to provide some money.
2. Marketable Securities: They are short-term, easily convertible debt securities used for financing through sale into cash.
3. Accounts Receivable: The monetary amount of claim that exists on customers for products or services that have been rendered and which the firm expects to collect within the near future.
Quick Ratio Formula
The formula for the quick ratio is:
Quick ratio = Quick Assets/Current Liabilities
Where:
Quick Assets refers to cash and cash equivalents, marketable securities, and accounts receivable. The asset accounts are generally classified into current assets, expected to be converted into cash or other assets within one year. Hence, it falls under the organisation’s current liabilities.
Current liabilities are the obligations of a particular company that are due in the next year or within the current financial year. These are short-term debts, accounts payable, and other current liabilities.
How to Calculate Quick Ratio?
To calculate the Quick Ratio, there are specific steps that need to be followed:
According to the formula above, it is inevitable that the quick ratio formula must be followed in order to arrive at an accurate result. Just follow these steps to have an accurate calculation:
1. Recognition of Current Assets:
Firstly, identify the existing assets that may be easily converted into cash. These include all money available, cash available in bank, marketable securities, as well as receivables from customers. These are generally recorded on a business’s balance sheet.
2. Find the Current Liabilities:
Discover the existing companies’ obligations. Accounts payable, short-term note payable, and accrued expenses are examples of current liabilities, which are liabilities for the amount due within one fiscal year.
3. Plug the numbers into Quick Ratio Formula:
Now, plug the numbers into the quick ratio formula.
Assume the following balance sheet of a company
- Cash $ 40,000
- Marketable Securities $30,000
- Accounts Receivable $ 60,000
- Current Liabilities $ 150,000
Now, use the quick ratio formula to calculate.
Quick Ratio = 40,000 + 30,000 + 60,000/150,000 = 130,000/150,000 = 0.87
Therefore, the result is 0.87, and it suggests that the company does not hold liquid assets to cover its short-term liabilities, so it is supposed to face serious problems when meeting obligations without other means of income or selling inventory.
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Importance of Quick Ratio
The quick ratio is quite important component of financial analysis and business decisions for the following reasons:
1. Liquidity Measurement:
This is a direct view of the company’s liquidity, which considers only the most liquid assets. As this ratio excludes inventory, unlike the current ratio, it tends to be a stricter and more immediate test of a company’s ability to pay its short-term debts.
2. Creditworthiness:
Lenders and investors typically examine the quick ratio before issuing credit or investing in a firm. Firms with a higher quick ratio often appear more capable of settling their debts and, thus less risky for creditors.
3. Operational Insights:
Low quick ratios point to companies facing liquidity issues and may be a red flag regarding the inefficiencies of managing their working capital. Businesses may pro-actively take steps to enhance liquidity either by cash flow tweaks or accounts receivables management.
What is an ideal Quick Ratio?
There is no standardised answer to what would represent the ideal quick ratio. In practice, an acceptable quick ratio is 1:1, indicating one dollar of quick assets for each dollar in short-term liabilities.
- A quick ratio greater than 1 means that liquid assets are more than sufficient to pay for short-term liabilities, which is considered a good indicator of the company’s financial soundness.
- If the quick ratio is less than 1, then the company has potentially serviced its short-term obligations by issuing additional funds or liquidating inventory, and this is likely associated with further liquidity problems.
For example, for companies whose businesses are mainly in retail or manufacturing, where much inventory is held, their ideal quick ratio would need to be lower because this kind of liquidity is tied up in the stock. For service-based companies that do not hold much stock, their ideal quick ratio may be higher and targeted to ensure there is adequacy in terms of financial flexibility.
How to Interpret the Quick Ratio?
The interpretation of the quick ratio depends on several factors. These factors include the company’s industry, business model, and current financial situation. Here’s how you approach the interpretation of the quick Ratio:
1. Quick Ratio More than 1:
A quick ratio of more than one ensures that the more liquid assets are compared with short-term liabilities. Thus, it indicates a company is in an excellent liquidity position and should not face many difficulties in meeting its current liabilities.
2. Quick Ratio Less than 1:
If the quick ratio is less than 1, then it could warn of a liquidity problem since the company lacks liquid assets to pay off short-term debts. At this point, a company may need to sell its inventories or other financing channels to satisfy its liabilities.
3. Quick Ratio close to 1:
A quick ratio close to 1 means that the company has just enough liquid assets to meet its current liabilities. It does not necessarily mean something is wrong with the company, but at least this is not a liquidation signal. The company has very little room for manoeuvre; it barely floats above the water, and any unexpected expense or cash flow shortage will likely cause liquidity problems.
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4. Trend Over Time:
The quick Ratio over time also needs to be examined. Decline in quick ratio might be an issue that the company is liquidating more and more and an increasing quick ratio would signify a healthier financial standing.
Conclusion
The quick ratio gives an important financial measure to indicate how well a company can pay off short-term debts using some of its most accessible assets. It indicates the very explicit and conservative view regarding the liquidity position of the company. The ratio is highly instrumental in carrying out several analyses on behalf of various businesses, investors, and lenders regarding the well-being of a company.
Deeper analysis of liquidity and financial ratios can be accessed by professional advice from experts such as SMC Global Securities for such needs. They will give you customised suggestions on the best course to follow for investors and companies in managing their finances responsibly.
FAQs on Quick Ratio
1. What is quick ratio?
Quick ratio, or acid test ratio, is a measure of the companies’ abilities to pay the short-term liabilities using their most liquid assets. This ratio does not take into account the calculations of inventory and prepaid expenses. Therefore, it gives the reader a more conservative estimate of liquidity.
2. How do you calculate the quick ratio?
Quick Ratio Formula
Quick ratio = Quick Assets / Current Liabilities
Quick assets consist of cash, marketable securities, and accounts receivable. Current liabilities are those obligations that are due to be paid in the immediate future i.e., within the next 12 months; account payables and short-term debt.
3. Why is it important to calculate the quick ratio?
- It shows a direct assessment of the liquidity of a company
- It can help evaluate a firm’s creditworthiness
- It can unveil potential liquidity problems in business and assist firms in ending their financial distress.
4. What is a good quick ratio?
Usually, a quick ratio of 1:1 is sufficient, in that the business has sufficient liquid assets to cover short-term liabilities. However, the perfect quick ratio varies from one industry and company to another.
5. How do I interpret the quick ratio?
- A quick ratio of more than 1 indicates a good liquidity position.
- A quick ratio below 1 may reflect potential liquidity problems.
- A quick ratio close to 1 means only just enough liquid assets to cover current liability.
- Analysing a quick ratio over time can indicate the trend of a company’s liquidity.
Author: All Content is verified by SMC Global Securities.
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