What is Quick Ratio?
The quick ratio measures a company’s ability to pay off short term obligations with liquid assets. In other words, the quick ratio is an accounting ratio that measures a company’s liquidity. It is also known as the acid test ratio as it tests the ability of a company to convert its quick assets into instant cash. The ratio measures the rupee amount of liquid assets available against the rupee amount of current liabilities. Liquid assets or quick assets are those assets that can be instantly converted into cash with a low impact on the price received in the open market. Whereas current liabilities are those expenses that become payable in one year’s time.
Quick ratio considers quick assets and current liabilities for its calculation. The ideal measure is 1:1. Anything less than that indicates the company’s liquidity is low.
Quick Ratio Formula
The Formula for the Quick Ratio is:
Quick Ratio = Quick or Liquid Assets / Current Liabilities
How to Calculate Quick Ratio?
|(Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities||(Current Assets – Inventory – Prepaid Expenses) / Current Liabilities|
Illustration on How To Calculate Quick Ratio –
|Cash and Cash Equivalents||Rs 1,80,000|
|Marketable Securities||Rs 3,20,000|
|Accounts Receivable||Rs 4,20,000|
|Total Current Assets||Rs 14,80,000|
|Prepaid Expenses||Rs 80,000|
|Current Liabilities||Rs 12,00,000|
|Using Method-1 Quick Assets|
(Cash and Cash Equivalents + Marketable Securities + Accounts Receivable)
(Rs 1,80,000 + Rs 3,20,000 + Rs 4,20,000)
(Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
(Rs 9,20,000 / Rs 12,00,000)
|Using Method-2 Quick Ratio|
(Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
(Rs 11,60,000 / Rs 12,00,000)
(Rs 14,80,000 – Rs 2,40,000 – Rs 80,000) / Rs 12,00,000
What is Included in the Quick Ratio?
The two main components are liquid assets or quick assets and current liabilities.
These are the most liquid assets owned by the company. They can be easily converted into cash in a short period of time. While converting quick assets into cash, the company shouldn’t incur high costs. For an asset to be a quick asset, there should be minimal to no loss in value during the conversion of these assets to cash. Quick assets include cash, accounts receivable and marketable securities. In other words, these are current assets without inventory and prepaid expenses.
A company’s short-term obligations that become due in the next year are current liabilities. One can easily find them in the company’s balance sheet. Short term debt, accounts payable, outstanding expenses, and other short-term borrowings all come under current liabilities.
Importance of Quick Ratio
Creditors and investors use the quick ratio to determine whether a company is a suitable option for funding or investment. It enables investors and creditors in understanding the readiness of a company to face any financial unexpected crisis. If cash flow becomes a concern, the quick ratio is a crucial indicator of the company’s capacity to satisfy short-term obligations.
However, it is vital to note that this metric does not indicate how the company will meet its obligations when cash flow is regular. It should only be used to understand two things. Firstly, the company’s ability to recover from an emergency circumstance in which it had to spend a considerable amount of money. Secondly, it indicates whether a temporary outflow of considerable cash will have an impact on the company’s day-to-day operations. Moreover, it shows whether in this situation the company will be able to recover quickly or not.
Analysis of Quick Ratio
High or Good Quick Ratio
A quick ratio of 1 or above indicates that the company has sufficient liquid assets to satisfy its short-term obligations. An extremely high quick ratio, on the other hand, isn’t always a good sign. This is because a very high ratio could indicate that the company is resting on a significant amount of cash. This idle cash could be better invested in the business or investment schemes to earn interest or returns.
The best quick ratio for a company depends on a variety of factors. Such factors include the industry it operates in, the markets it serves, its maturity, type of business, the cycle of debtors and creditors, and its creditworthiness.
For instance, an MNC with high creditworthiness and maturity in the industry will be able to survive any financial turbulence. Owing to its relationship with creditors, lenders, and debtors, this company will be in a better position to negotiate payment terms and forecast its market. While on the other hand, this is not applicable to a small business. For a small business, the challenges of maintaining liquid assets are tremendous. It deals with other small businesses that may or may not have a strong financial uphold on their cash flow.
Low Quick Ratio
Businesses with a quick ratio of less than 1 have insufficient quick assets to meet their financial obligations in the event of a financial crisis. This makes it difficult for the companies to repay their creditors and lenders.
If a company’s quick ratio is less than one, it suggests it lacks the ability to satisfy all of its short-term obligations. Furthermore, if the company wants to borrow money, it may have to pay exorbitant interest rates.
Limitations of Quick Ratio
The quick ratio’s fundamental flaw is that it believes a company will satisfy its obligations with its current assets. However, companies generally try to fulfil their obligations using operating cash flow rather than current assets. It solely evaluates a company’s ability to survive a liquidity constraint. The calculation neglects a company’s ability to meet obligations from operating cash flows.
Another shortcoming of the quick ratio is that it ignores other aspects of a company’s liquidity, such as payment terms, negotiation strength, and current credit terms. As a result, the quick ratio does not give the full picture of liquidity. To ensure an end-to-end exposure to a company’s liquidity status, analysts prefer combining quick ratio along with current ratio and cash ratio. Moreover, analysts compare these ratios to industry standards.
Quick ratio assumes that accounts receivable are readily available for conversion. However, it ignores the fact that accounts receivable are yet to be received. Moreover, the receipt also depends on the financial situation of the debtors. A debtor might not be able to pay as and when requested. In such a situation, the accounts receivable will be converted to bad and doubtful debts. In conclusion, it is presumed that the amount will be received while it is not established that debtors will surely pay their debts.
Advantages of Quick Ratio
During difficult circumstances, a company’s capacity to leverage cash and other short-term assets might be critical to its survival. To meet urgent obligations, businesses with cash flow challenges may have to sell inventory at a massive discount or borrow at extremely high interest rates. This measure is a useful metric for determining a company’s ability to deal with cash flow challenges without resorting to boost sales at discounts or borrowing money.
Difference Between Current Ratio and Quick Ratio
The major difference between the quick ratio and the current ratio is that quick ratio is more conservative than the current ratio. The quick ratio considers the assets that are much quicker to convert into cash. It considers cash and cash equivalents and marketable securities as quick assets. Obviously, cash is readily available in-hand cash or bank balance. Moreover, marketable securities are investments that can be redeemed anytime and redemption value can be received in less than 7 days. In addition to these quick assets, accounts receivable are considered quick assets as well. Owing to the nature of the asset, accounts receivable are owned by the company. Hence, a natural entitlement is attached to accounts receivable that can be recovered in the short term.
On the other hand, the current ratio considers inventory in the calculation. Now inventory is a current asset. However, it cannot be considered a quickly convertible asset. This is because inventory will go through the entire cycle starting from sales negotiation to accounts receivable. After this cycle, it will be a quick asset.
Hence, the quick ratio presents an enhanced realistic picture of the financial liquidity of a company. However, while evaluating a company’s liquidity, an analyst must consider all the 3 ratios namely quick ratio, current ratio, and cash ratio.