What is a Quick Ratio?
The quick ratio is a measure of the short-term solvency of a business. 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, easily marketable securities, and AR (Accounts Receivable), excluding inventories. And 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.
We can also address it as an improved version of the current ratio in many aspects. We also call it the acid test ratio.
This ratio is a type of liquidity ratio and is useful not only to internal finance managers but equally useful to creditors, lenders, banks, investors, etc. Normally, the wide use of the current ratio takes place in bank finance, but for businesses with a liquidity crunch, banks may consider giving more importance to the quick ratio. It is a ratio for taking care of the defects in the current ratio. In other words, we can also say that it is an extended version of the current ratio.
Both these ratios deal with the liquidity position of a business. The quick ratio is also known as the acid test ratio, which is an astringent or tough test of liquidity as compared to the current ratio.
How to calculate Quick Ratio using its Formula?
The calculating quick ratio is a cakewalk if the current ratio is already calculated. It is a ratio of quick current assets and quick current liabilities. Quick current assets refer to current assets less the value of inventory and prepaid expenses, and quick current liabilities refer to current liabilities less bank overdraft and cash credit.
For calculation, you can use the Quick Ratio Calculator
The formula for it can be in two forms:
|Quick / Acid Test Ratio = Quick Current Assets / Quick Current Liabilities|
Current Assets less Inventory and Prepaid Expenses / Current Liabilities less Bank Overdraft and Cash Credit
Cash + Marketable Securities + Accounts Receivables / Creditors / Accounts Payable
Explanation of Components – Quick Assets and Liabilities:
The only distinction between the quick asset and the current asset is for inventory and prepaid expenses. The distinction is because of the reason that inventory is less liquid in comparison 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 the payments made in advance for some reason. We exclude these because we cannot reverse the payment and therefore are not liquid like the other quick assets.
The distinction between quick liabilities and current liabilities is of bank overdraft and cash credit. It is because they are secured by inventories. Therefore, quick current liabilities are 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.
FULL RATIO ANALYSIS (32 RATIOS)
We have covered the complete ratio analysis – its significance, application, importance, and limitations, and all 32 RATIOS of ratio analysis that are structured and categorized into 6 important heads.
Example or Illustration for Calculation
Consider the following example to understand the concept well:
|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
= (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
= (225000 – 15000 – 65000) / (111000 – 6000 – 10000) = 145000 / 95000 = 1.53
And, Current ratio = Current Assets / Current Liabilities = 225000 /111000 = 2.03
What is a Good Quick Ratio?
A quick ratio of 1:1 is considered good because the assets included in the calculation are liquid assets easily converted into cash without shrinkage in value. A firm with a quick ratio of 1:1 is considered to have sufficient liquidity. It is capable enough to pay off all the liabilities/bills on time. A quick ratio of 1:1 simply means that the firm has liquid assets equal to the liabilities that we need to pay off. It is a reliable ratio because assets forming part of quick assets are easily convertible into cash on short notice without shrinking in value.
A detailed interpretation, along with how to improve the ratio, is presented in our following post.
Difference between Current Ratio and Quick Ratio
The difference between a current ratio and a 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.
The technical difference or, say, a defect of current assets is that the entire current asset pool, such as cash and inventory, is 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, the conversion of inventory into cash does not take place directly but via debtors. The current asset gives an understanding of the liquidity position of a firm that will suffer if the inventory needs liquidation because of two reasons – the time of liquidation and the diminution of the value of inventory.
In the above example, the difference between the current ratio (2.03) and the quick ratio (1.53) is positive, i.e., the quick ratio is less than the current ratio by 0.5. This is an alarming situation for bankers because liquidity is hampered by the presence of a higher level of inventory.
Keep reading: Advantages and Disadvantages of Acid Test Ratio.
Quiz on Quick Ratio