The quick ratio is a measure of short-term solvency of a business. It is said to be an improved version of current ratio in many aspects. A quick ratio of 1:1 is considered good because the assets included in the calculation of quick ratio are cream assets easily converted into cash without shrinkage in value. It is also known as acid test ratio.
The quick ratio, a measure of liquidity of a business, is useful not only to the internal finance managers but equally useful to creditors, lenders, banks, investors etc. Normally current ratio is widely used for bank finance but for businesses with liquidity crunch, banks may consider giving more importance to quick ratio. It is a ratio developed to take care of the defects in Current Ratio. In other words, we can also say that it is an extended version of Current Ratio.
Both these ratios deal with the liquidity position of a business. The quick ratio, which is better known as Acid Test Ratio, is a stringent or tough test of liquidity as compared to Current Ratio.
How to calculate Quick Ratio using its Formula?
The calculating quick ratio is a cake walk if Current Ratio is already calculated. It is a ratio of quick current assets and quick current liabilities. Quick current assets are defined as current assets less the value of inventory and prepaid expenses and quick current liabilities are defined as current liabilities less Bank Overdraft and Cash Credit.
Quick Ratio Formula:
The formula for quick ratio can be presented in two forms:
|Quick Current Assets|| |
Current Assets less Inventory and Prepaid Expenses
|Quick / Acid Test Ratio||=||————————||=||————————————————————-|
|Quick Current Liabilities||Current Liabilities less Bank Overdraft and Cash Credit|
|Quick Current Assets||Cash + Marketable Securities + Accounts Receivables|
|Quick / Acid Test Ratio||=||————————||=||——————————————-|
|Quick Current Liabilities||Creditors / Accounts Payable|
Explanation of Components – Quick Assets and Liabilities:
The only distinction between quick asset and the current asset is for inventory and prepaid expenses. The distinction is created because inventory is considered to be less liquid as compared to other components of a current asset like cash, short-term loans, debtors and bills receivables, marketable instruments, short-term securities etc. Similarly, the prepaid expenses as the term suggests are paid in advance for some reason. They are excluded because the payment cannot be reversed and therefore are not liquid like the other quick assets.
The distinction between quick liabilities and current assets is of Bank Overdraft and Cash Credit. It is because they are secured by Inventories. Therefore, quick current liabilities are defined as current liabilities less the value of bank overdraft and cash credit.
** For a detailed calculation of current assets and liabilities refer to the article: Current Ratio.
Example or Illustration for Calculation
Quick Ratio can be understood well with an example as below:
|Current Assets|| |
|Current Liabilities||Amt (USD)|
|Cash||35000||Creditors / Accounts Payable||95000|
|Marketable Securities||20000||Bank overdraft||10000|
|Accounts Receivable||90000||Cash credit||6000|
|Total Current Assets||225000||Total Current Liabilities||111000|
Solution by Both Formulae
Quick ratio = Cash + Marketable Securities + Accounts Receivables / Accounts Payable + Bank Overdraft + Cash Credit
Quick ratio = (35000 + 20000 + 90000) / 95000 = 145000 / 95000 = 1.53OR
Quick ratio = Cash Current Assets less Inventory and Prepaid Expenses / Current Liabilities less Bank Overdraft and Cash Credit
Quick ratio = (225000 – 15000 – 65000) / (111000 – 6000 – 10000) = 145000 / 95000 = 1.53
And, Current ratio = Current Assets / Current Liabilities = 225000 /111000 = 2.03
Interpretation (Analysis) of Quick / Acid Test Ratio
A firm with a quick ratio or acid test ratio of 1:1 is considered to have sufficient liquidity. It is capable enough to pay off all the liabilities / bills on time. Quick Ratio of 1:1 simply means that the firm has liquid assets equal to the liabilities that are to be paid off. It is a reliable ratio because assets forming part of quick assets are easily convertible into cash in a short notice without shrinking in value.
Difference between Current Ratio and Quick Ratio
The difference between a current ratio and quick ratio in terms of its calculation is that the numerator is changed from current assets to quick assets and the denominator is changed from current liabilities to quick liabilities. This difference is explained in the above definition of quick assets and liabilities.
The technical difference or say a defect of current assets is that the entire current asset pool such as cash and inventory are weighted equally. In view of liquidity, inventory is difficult to be liquidated (without the reduction in value) compared to other current assets such as debtors etc. The conversion of inventory into cash has a hurdle step of ‘receivables’ in between because normally inventory will not be directly converted into cash but via debtors. The current asset gives an understanding of the liquidity position of a firm which will suffer if the inventory needs liquidation because of two reasons – the time of liquidation and diminution of value of inventory.
In the above example, the difference between the current ratio (2.03) and quick ratio is (1.53) is positive i.e. quick ratio is less than current ratio by 0.05. This is an alarming situation for bankers because the liquidity is hampered by the presence of higher level of liquidity.