‘Quick Ratio’ refers to the liquidity ratio that assesses the ability of a company to cover its short-term liabilities. This is done by calculating all assets that can be easily converted into cash. The name itself ‘Quick Ratio’ comes from the idea that the only those assets that can be quickly liquidated are used to calculate.
Another name of the ‘Quick Ratio’ is ‘Acid Test Ratio’.
Numbers considered as Quick assets are:
- Marketable securities
- Accounts receivables
- Other Current Asset
‘Quick Ratio’ is a relatively more conservative approach to current ratio as it only uses assets that are cash or cash equivalent to assess the ability to repay the short-term liabilities.
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Quick Ratio Formula
Quick Ratio can be calculated by dividing the sum of cash, marketable securities, accounts receivables and other current assets by the total current liabilities.
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable + Other Current Assets) / Total Current Liabilities
The other way of calculating the Quick Ratio is by subtracting inventories and prepaid expenses from total current assets followed by dividing by the total current liabilities.
Quick Ratio = (Total Current Assets – Inventories – Prepaid Expenses) / Total Current Liabilities
How to interpret quick ratio?
Calculated Quick Ratio of a company is Equal to 1
When the calculated quick ratio is 1, it means the liquid assets are equal to its current assets. This also means that the company is able to pay off its current debts without selling its long-term assets.
Calculated Quick Ratio of a company is Greater Than 1
When the calculated quick ratio is greater than 1, it means the company have more than enough liquid assets to be used to repay the current liabilities. This is a good quick ratio and the most desirable quick ratio of a company.
Calculated Quick Ratio of a company is Smaller Than 1
When the calculated quick ratio is less than 1, it means that the company does not have enough liquid assets to be used to repay the current liabilities. This is a bad quick ratio of a company.
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John is a smart investor who is thinking of investing at ABC Company.
John knows that if he do a proper fundamental analysis of the company, he can understand more about the financial health of the company. Thus he will be able to make a better informed decision before he put his money into the company.
Quick Ratio is just one of the many fundamental analysis numbers that John need to calculate. This number allows him to have a rough gadget of the financial health of the company he is going to invest.
The company has provided the following information in the website:
|Information Provided On The Balance Sheet|
|Net Account Receivable||$2,000|
|Total Current Liabilities||$1,500|
What is quick ratio with the example?
Out of the above mentioned current assets; only cash, marketable securities and net receivable can be considered to be quick assets.
Quick ratio is calculated as follows
Quick Ratio = (Cash + Marketable Securities + Net Accounts Receivable) / Total Current Liabilities
Quick Ratio = ($1,000 + $2,000) / $1,500
Quick Ratio = 2.0
The calculated quick ratio of the company is 2.0. The calculated Quick Ratio is more than 1.0 which is a comfortable liquidity position.
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advantages and disadvantages of quick ratio
advantages of quick ratio
- Quick Ratio is a conservative liquidity ratio. The ratio calculated only uses assets that can be quickly converted to cash to assesses the ability to repay current liabilities.
- Inventories is not used as it takes too long to convert inventories into cash. This helps investors and management to have a clearer idea about the liquidity position of the company.
- Quick Ratio is one of the easiest ratios to understand. Thus people who do not have a deep understanding of accounting and finance tend to use this ratio for assessment.
- Illustrated as a ratio, Quick Ratio can be used to compare companies.
Tip: Use Quick Ratio to compare companies that have similar size and industry.
disadvantages of quick ratio
- Quick Ratio doesn’t provide any information about the company’s cash flow. Cash flow of a company are always one of the most important factors in the assessment of the liquidity of a company.
- Some assumptions such as account receivable might not be as such readily available for collection. This is especially true during a market downturn.
- During a market down turn, marketable securities may find it difficult to trade in the market.
why is quick ratio important to investors
Quick ratio measures a company’s capacity to pay its current liabilities without needing to sell its inventory or obtain additional financing.
Quick Ratio is a great tool to measure the liquidity of a company. Quick Ratio is a liquidity ratio analysis that is more conservative approach than the Current Ratio but less conservative than Cash Ratio.
These liquidity ratio helps the investors to assess the liquidity position of a company.
Learning these fundamental analysis is an important step for you to become a smart investor.
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Disclaimer: I am not your financial adviser or lawyer, information found in our website are just my opinions and should used for entertainment purpose only. You should always ask your financial adviser or lawyer for any financial or law related advice.