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Quick or Acid Test ratio is the proportion of the quick assets to quick current liabilities of a business. Quick assets include all cash and cash equivalents, securities that are easily marketable and AR (Accounts Receivable) and specifically exclude inventories. Quick current liabilities include all current liabilities except bank overdraft and cash credit. It measures the capability of an organization to pay its obligations by utilizing its quick assets. The article throws light on ways to interpret and improve the quick / acid test ratio.
Understanding Quick Ratio or Acid Test Ratio
The quick ratio is a ratio calculated to handle the defects that are present in Current Ratio. The acid-test ratio is a more progressive form of an alternate well-known liquidity metric – the current ratio. Despite the fact that the two are comparable, the Acid-Test ratio gives a more thorough appraisal of an organization’s capability to pay its current liabilities.
Acid test ratio eliminates all except the most liquid of current stakes. The stock is the most striking rejection, in light of the fact that it cannot be quickly converted to cash. Similarly, bank overdraft and cash credit are excluded from current liabilities because they are secured by inventories. A few investigators incorporate stock in the ratio due to its liquidity when compared to other receivables. Alternatively, quick ratio can also be computed by means of the following formula:
|Quick Ratio||=||Current Assets ? Inventory – Prepayments|
|Current Liabilities – Bank Overdraft and Cash Credit|
Interpretation of Quick Ratio / Acid Test Ratio
Quick ratio evaluates the liquidity of a company by comparing its cash plus almost cash current assets with its entire current financial obligations. It assists in verifying if the business or company has the capacity to pay off its current liabilities by means of the most liquid assets.
A firm with a quick-or-acid-test-ratio of 1:1 is considered to have sufficient liquidity. It is fit enough to pay off all the liabilities / bills on time. Consequently, it might be said that, for the most part, a higher quick ratio is best in light of the fact that it implies more noteworthy liquidity. However a ratio of 4:1 is not good for a business as this implies that the business has 4 times idle current assets against the requirement of 1. These idle assets could have been utilized to make extra money consequently contributing to net profits. Put differently, an exceedingly high rate of the quick ratio may point out incompetence in financial management. An excellent authority is to locate an industry standard and then contrast the current and acid test ratios of the business alongside this industry average.
How to Improve Quick Ratio?
The quick ratio is valuable to the in-house financial directors as well as creditors, loaners, banks, capitalists and so on. A business has to closely work with all these stakeholders and they consider quick ratio as a measure of liquidity of a business and accordingly extend their support. It is better to keep this ratio controlled and managed.
One of the quickest ways to improve the quick ratio would be to pay off the current bills and at the same time increase sales so that the cash on hand or AR increases. As the quick ratio is similar to the current ratio but does not include stock in current assets, it can be improved by similar actions that increase the current ratio.
Here are some ways of improving quick ratio:
- Improving Inventory Turnover Ratio: By faster conversion of inventory into debtors and cash, the quick assets would rise resulting in an improvement in the quick ratio.
- Discarding Unproductive Assets: If the company has any unproductive assets, it is better to sell them and have better liquidity. Reduction of such assets would result in better cash position and therefore improvement in the numerator of quick ratio.
- Improving the Collection Period or ARs: Reduction in collection period will have a direct impact on the quick ratio. Lower collection period means faster rolling of cash. Improvement in collection period can result in a number of debtor’s cycle during the year resulting in better current assets. Moreover, the chances of long-term debtors, sticky debtors and bad debts also reduce. Right from the beginning the terms of payment have to be made clear so as to get credit period as low as feasible.
- Paying off Current Liabilities: Current liabilities which form a part of the denominator of the quick ratio are to be reduced in order to have the better current ratio. This can be done by paying off creditors faster or quicker payments of loans. Lower the current liabilities, better the quick ratio is.
- Drawings: Drawings for non-business reasons like owners’ withdrawals have to be kept at the minimum level. The increase in drawings means a reduction in owner’s funds in the current assets. This would give rise to higher level of current liabilities to fund the current asset instead of the use of owner’s fund used for current assets. This will result in the direct reduction of quick ratio. It is best to have profits ploughed back in business and capital should be maintained ideally so as to balance the current ratio. Higher the drawings, lower the current ratio would be.
- Sweep Accounts: Sweep accounts can be used to earn interest on any extra money by ‘sweeping’ or moving the idle cash into an account which brings interest when the finance is not required and sweeping them back into the working account when it is required. This will enable the management to keep the quick ratio high by keeping the cash in hand and still not loosing on the opportunity of better interest rates by reducing a cost of idle funds.
Such steps can help in stopping avoidable cash drain out of the business. When the above easy tips are implemented the business is sure to perk up liquidity.
Principles of Management Accounting – MANMOHAN & S. N. GOYAL, Sahitya Bhavan, Agra