If a company needs to raise money fast to meet its financial obligations, it needs to know how much money it has available. Quick ratio is used to work out whether a business has sufficient liquid assets it could convert to cash to pay off its current liabilities.
Also, known as the acid-test ratio or the liquidity ratio, the quick ratio is a good indicator of a company’s financial health.
How is quick ratio calculated?
The quick ratio formula is straightforward – it is the sum of all your current assets (cash, cash equivalents or marketable securities, and accounts receivable) divided by current liabilities.
The equation looks like this:
Current assets / Current liabilities = Quick ratio
The information you need for this ‘acid test’ of your company’s financial health can be found on your balance sheet.
Interpreting quick ratio results
The quick ratio gives an at-a-glance view of your company’s solvency and can be a good indicator of your long-term position.
A score of one or higher is a positive measure of a company’s liquidity position – it could instantly cover all its short-term financial obligations if it had to, without having to sell off any long-term or capital assets. It’s more appealing to lenders, investors and suppliers because it demonstrates good business practice, decent cash-flow and the potential for sustainable growth.
Less than one means a company has insufficient liquid assets to pay off its short-term liabilities. If it suffered business disruption, for example, it might struggle to raise funds to pay off its creditors and might have to sell off capital assets to meet its obligations. Companies generally try to avoid doing this because they use capital assets to generate revenue.
A deeper look at what a quick ratio includes
A quick ratio includes cash, cash equivalents or marketable securities, and accounts receivable. Let’s look at the definitions of these in greater detail:
Cash – The amount held in any current or savings accounts
Cash equivalents/marketable securities – Money market instruments, treasury bills, short-term government bonds, commercial paper and any other securities held for investment such as stocks and bonds
Accounts receivable – Any money owed to a company by its debtors
Accounts payable – Suppliers/creditors that are owed money
Short-term debts – Any debts that fall due within 12 months
Accrued liabilities – Any obligations a business may have but for which a creditor has not yet issued an invoice
The acid-test ratio only takes into account assets which can be converted into cash in 90 days or less.
Quick ratio or current ratio?
The quick ratio is often considered a better indicator, or liquidity ratio, than current ratio of a company’s debt-to-equity position.
The calculation for current ratio is the same except it also includes inventory and prepaid expenses in its current assets. The quick ratio excludes these.
For service businesses which don’t have much inventory, this isn’t an issue, but for businesses which carry a lot of inventory it’s problematic. Inventory can be hard to liquidate fast and it often occurs at a loss. In reality, it’s not always something a business could rely on for quick cash flow. Using the current ratio can skew the result so it appears higher than if using the acid-test ratio.
Frequently asked questions
How do you interpret quick ratio?
A ratio of one means its current assets are equal to current liabilities. More than one means it has more than enough quick assets to pay off its debts; less than one and it wouldn’t have the liquidity to do so.
What do quick ratios tell us?
Whether a company has enough quick assets to pay off its current liabilities. It can be a good indication of a company’s overall financial health.