Have you ever heard of giving something the “acid test”?
The quick ratio is a sort of financial acid test to make sure a company’s short term financial outlook is looking good.
The quick ratio is a financial metric that measures a company’s ability to meet its short-term liabilities with its most liquid assets. Quick ratios are especially important for investors, who like to know when a company is in danger of not being able to meet its obligations.
The formula for calculating the quick ratio is:
QUICK RATIO DEFINED VERSION #1
Quick Ratio = (Cash and Equivalents + Accounts Receivable) / Current Liabilities
Some analysts like to express the quick ratio in another way, as shown below.
QUICK RATIO DEFINED VERSION #2
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
Here’s a breakdown of the components:
- Cash and Equivalents: These are assets that are expected to be converted into cash or used up within one year. Common examples include cash, accounts receivable, and short-term investments.
- Accounts Receivable: Accounts receivable (AR) is the money that a company’s customers owe for goods or services that have been delivered or used but not yet paid for.
- Inventories: This includes the value of goods or products that a company holds in stock. Inventories are excluded from the quick ratio because they are not as easily converted to cash in the short term.
- Current Assets: Current assets include Cash and Equivalents as well as Inventories.
- Current Liabilities: These are obligations or debts that are expected to be settled within one year. Examples include accounts payable, short-term debt, and other short-term obligations. It can also include wages, taxes payable, and the current portion of long-term debt.
The quick ratio provides a more conservative measure of a company’s liquidity compared to the current ratio, as it excludes inventories. This is because inventories may take time to sell and convert into cash. In a short-term liquidity assessment, these will not be as readily available as other current assets.
CURRENT RATIO DEFINED
Current Ratio = Current Assets / Current Liabilities
How do I calculate Quick Ratio and Current Ratio?
Here’s an example of how to calculate the Quick Ratio and the Current Ratio using a fictional company in Atlanta called GoodCompany.
Here’s the facts:
- GoodCompany has $30,000 in the bank (cash and equivalents)
- GoodCompany has $100,000 in AR (accounts receivable)
- GoodCompany holds $50,000 in inventory (inventories)
- GoodCompany has two loans to be settled this year, each at $10,000 (current liabilities)
Cash and Equivalents = $30,000
Accounts Receivable = $100,000
Inventories = $50,000
Current Assets: $180,000
Current Liabilities = $20,000
($30,000 + $100,000) / $20,000 = 6.5 (version #1)
($180,000 – $50,000) / $20,000 = 6.5 (version #2)
$180,000 / $20,000 = 9
In this case, GoodCompany looks like it is in great shape to meet its short term obligations and its investors can rest easy. In fact, they may soon ask questions about why the company is hoarding cash when there is growth to be had.
What Is A Good Quick Ratio?
A quick ratio of less than 1 means that your company does not have the capital it should have on hand to meet all its obligations if they were called all at once. While this is unlikely, it is not impossible as the historic “runs on the bank” have shown.
Sometimes lags in accounts receivable or even just seasonal billing patterns can bring a company’s current ratio artificially low for a temporary period. If the payments are made, the company should be fine.
A quick ratio of 1 or higher is generally considered healthy. This indicates that a company has enough liquid assets to cover its short-term liabilities.
Above 1.50 means that the company is solvent and likely to remain so, though nothing is guaranteed.
A quick ratio that gets high, such as 3 or larger, means that it may not be properly deploying the current assets that it has. This can mean opportunity cost, lost growth, and missed expectations down the road. Every company has to manage its working capital properly.
Some items that can cloud the effectiveness of a Quick Ratio include:
- If you have accounts that are in danger of not fulfilling their full contract payment terms
- Inventory might not be as easily sold as would be expected, or it might be worth far less than expected
However, what is considered a good quick ratio can vary by industry, so it’s often useful to compare a company’s quick ratio to industry benchmarks or historical performance.
How Can I Improve My Company’s Quick Ratio?
Improving the quick ratio involves managing current assets and liabilities in a way that boosts liquidity.
There are many ways to improve your company’s quick ratio:
Reduce Inventory Levels:
Lowering the level of inventory can significantly improve the quick ratio. This can be achieved through efficient inventory management, just-in-time inventory practices, and regular inventory turnover analysis.
Improve Receivables Management:
Accelerate the collection of accounts receivable to convert them into cash more quickly. Offer discounts for early payments, implement more rigorous credit policies, and use collection strategies to reduce the average collection period.
Negotiate Favorable Payment Terms:
Negotiate longer payment terms with suppliers to delay cash outflows. However, be cautious not to jeopardize supplier relationships or incur additional costs.
Increase Cash Reserves:
Build up cash reserves by retaining earnings or securing additional lines of credit. Having more cash on hand improves liquidity and boosts the quick ratio.
Sell Unused or Surplus Assets:
Consider selling assets that are not essential for daily operations. This can include unused equipment, excess inventory, or underutilized facilities.
Streamline Operating Efficiency:
Improve overall operational efficiency to generate cash more quickly. This can involve optimizing production processes, reducing operating expenses, and eliminating inefficiencies.
Evaluate and Prioritize Liabilities:
Prioritize the payment of liabilities with a higher urgency, ensuring that the most critical obligations are addressed promptly. This can prevent late payment penalties and improve the quick ratio.
Renegotiate Debt Terms:
Explore opportunities to renegotiate debt terms to extend payment periods or reduce interest rates. This can provide more flexibility in managing short-term liabilities.
Monitor and Adjust Working Capital:
Regularly monitor working capital levels and adjust them based on business needs. Working capital management involves balancing current assets and liabilities effectively.
Forecast Cash Flow:
Implement robust cash flow forecasting to anticipate periods of higher cash needs and plan accordingly. This allows for proactive management of liquidity.
Invest in Marketable Securities:
Consider investing excess cash in short-term, highly liquid securities that can be easily converted to cash when needed. This can generate some return while maintaining liquidity.
Making the Most of the Quick Ratio
Keep in mind that while the quick ratio provides insights into short-term liquidity, it’s just one of many financial metrics that should be considered when evaluating your company’s financial health.
It’s important to analyze multiple financial ratios and metrics to get a comprehensive view of your company’s overall financial condition.
• Quick Ratio | Formula + Calculator at Wall Street Prep
• Quick Ratio – Formula, Example, Calculate, Template at Corporate Finance Institute
• Quick Ratio Formula With Examples, Pros and Cons at Investopedia