Ratio analysis is a crucial part of analysing a particular stock. It provides insights into the profitability, liquidity, solvency, revenue and earnings of a particular company.
Among these, the Quick Ratio is particularly significant, providing a clear view of a company’s capacity to fulfil its short-term liabilities with its most liquid assets.
In this article, we’ll read about the Quick Ratio, its importance in assessing a company’s financial health, and its pivotal role in making informed investment decisions.
Also Read More About Ratio Analysis
What is Quick Ratio?
The Quick Ratio, also called the Acid-Test Ratio, is an indicator for assessing a firm’s immediate liquidity status. This metric gauges a firm’s capacity to settle its short-term obligations using its most readily convertible assets, excluding the necessity to liquidate inventory. This ratio is a more stringent measure compared to the current ratio as it provides a better understanding of a company’s ability to meet its short-term obligations with assets that are readily convertible to cash.
Components of Quick Ratio
Quick Assets: These assets can be quickly converted into cash within 90 days or less. They include:
- Cash and Cash Equivalents: This includes cash in hand, bank balances, and short-term investments that can be easily converted into cash.
- Marketable Securities: These financial instruments can be sold quickly in the market, like stocks and bonds.
- Accounts Receivable: Money customers owe that is expected to be received in the short term.
Current Liabilities: These are the obligations of a company that are due within one year. They include:
- Accounts Payable: Funds that a business has to pay to its suppliers or vendors for the products and services it has received.
- Short-term Debt: Loans and borrowings that are due within the next 12 months.
- Other Short-term Liabilities: These might include accrued expenses, taxes payable, dividends payable, and other obligations due within a year.
Formula of Quick Ratio
The Quick Ratio calculates the company’s most liquid assets by its current liabilities. The formula for the Quick Ratio is
Quick Ratio = Quick Assets / Current Liabilities
Formula to calculate the Quick Ratio, including the variables.
Quick Ratio = (Cash and Cash Equivalents + Accounts Receivable + Marketable Securities) / Current Liabilities
Or
Quick Ratio = (Current Assets – Prepaid Expenses – Inventory) / Current Liabilities
Calculation of Quick Ratio
To illustrate how the Quick Ratio is calculated, let’s take an example to understand the calculations better.
Suppose we have the following data from a company’s balance sheet:
- Cash and Cash Equivalents: ₹30,000
- Marketable Securities: ₹20,000
- Accounts Receivable: ₹40,000
- Accounts Payable: ₹25,000
- Short-term Debt: ₹10,000
- Other Short-term Liabilities: ₹15,000
First, we calculate the Quick Assets by adding Cash, Other Cash Equivalents, Marketable Securities, and Accounts Receivable.
Quick Assets = Cash + Other Cash Equivalents + Marketable Securities + Accounts Receivable
Then, we calculate the Quick Ratio by dividing the Quick Assets by the Current Liabilities
Current Liabilities = Accounts Payable + Short-term Debt + Other Short-term Liabilities
Formula: Quick Ratio = Quick Assets/ Current Liabilities
Now, let’s perform these calculations.
Step 1:
Based on the given data, the calculations for the Quick Ratio are as follows:
Quick Assets:
- Cash and Cash Equivalents: ₹30,000
- Marketable Securities: ₹20,000
- Accounts Receivable: ₹40,000
- Total Quick Assets: ₹90,000
Current Liabilities:
- Accounts Payable: ₹25,000
- Short-term Debt: ₹10,000
- Other Short-term Liabilities: ₹15,000
- Total Current Liabilities: ₹50,000
Step 2: Quick Ratio Calculation:
Quick Ratio = Quick Assets / Current Liabilities
Quick Ratio = ₹90,000 / ₹50,000
Quick Ratio = 1.8
Therefore, the Quick Ratio for this company is 1.8. This suggests that for every ₹1 of current liabilities, the company has ₹1.8 in liquid assets, indicating a strong liquidity position
Quick Ratio vs Current Ratio
| Feature | Quick Ratio | Current Ratio |
| Definition | Assesses a company’s ability to meet short-term debts with its most liquid assets, such as cash. | Measures the company’s capacity to pay short-term obligations using all current assets, including those convertible into cash within a year. |
| Formula | (Current Assets−Inventory−Prepaid Expenses) / Current Liabilities | Current Assets / Current Liabilities |
| Components | Includes cash, marketable securities, and receivables. Excludes inventory and prepaid expenses. | Cash, receivables, inventory, marketable securities, and other current assets are included. |
| Focus | Focuses on the most liquid assets. | Focuses on all assets that are expected to be converted into cash within a year. |
| Liquidity Measure | More stringent measure of liquidity. | A broader measure of liquidity. |
| Industry Suitability | More suitable for industries where inventory is not easily converted into cash. | Suitable for all industries, particularly those with significant inventory. |
| Sensitivity | Less influenced by seasonal fluctuations in inventory. | Can be significantly affected by changes in inventory levels. |
| Indication | High ratio indicates a strong liquidity position but may also indicate underutilised resources. | High ratio indicates good liquidity but may also suggest excessive inventory or poor cash management. |
| Limitations | May overestimate liquidity if receivables are not easily collectable. | May overestimate liquidity, especially if inventory is slow-moving or obsolete. |
Also Read More About Liquidity Ratio
What is the Ideal Quick Ratio?
The ideal Quick Ratio can differ based on the industry and unique conditions of the company. However, a commonly used standard is a Quick Ratio of 1:1. This ratio indicates that a company possesses an adequate amount of liquid assets, including cash, marketable securities, and accounts receivable, to cover its current liabilities.
Importance of Quick Ratio
- Measure of Liquidity: It clearly indicates a company’s capacity to pay off its short-term liabilities with its most liquid assets. This is crucial for assessing the financial health of a business, especially in situations where quick asset conversion to cash is necessary.
- Excludes Inventory: Unlike the current ratio, the Quick Ratio does not include inventory in its calculation. Since inventory can sometimes be difficult to liquidate quickly and its value can fluctuate, the Quick Ratio offers a more stringent and reliable measure of a company’s immediate liquidity.
- Risk Assessment for Creditors and Investors: Creditors and investors use the Quick Ratio to assess the risk involved in lending to or investing in a company. A higher Quick Ratio suggests that a company can more readily meet its short-term obligations, making it a lower risk for short-term creditors.
- Financial Stability and Flexibility: A healthy Quick Ratio indicates that a company has enough liquid assets to cover its short-term liabilities, which implies financial stability. This also allows the company to handle unexpected expenses or financial downturns without resorting to additional debt.
- Comparative Analysis: The Quick Ratio can be used to compare the liquidity of different companies within the same industry. This comparison is helpful for management, investors, and analysts to gauge a company’s performance relative to its peers.
- Indicator of Operational Efficiency: A consistently high Quick Ratio might indicate good management practices in managing receivables, cash, and short-term investments. It reflects the company’s efficiency in utilising its assets.
- Forecasting Financial Challenges: A low Quick Ratio might signal potential financial difficulties. It alerts management to take corrective actions, such as improving cash flow, reducing liabilities, or reevaluating credit policies.
Limitations of Quick Ratio
Despite its usefulness, the Quick Ratio has several limitations:
- Does Not Consider Timing of Cash Flows: The Quick Ratio assumes that receivables and other quick assets can be readily converted into cash. However, it does not account for the timing of these cash flows, which can be critical in a liquidity crunch.
- Varies by Industry: The significance of the Quick Ratio can vary greatly across different industries. For example, industries with fast-moving inventory might not need as high a Quick Ratio as those with slower inventory turnover.
- Quality of Receivables Ignored: The Quick Ratio considers accounts receivable as liquid assets, but it does not consider the quality or collectibility of these receivables. Bad debts can inflate the Quick Ratio, giving a misleading picture of financial health.
- Inventory Exclusion Can Be Misleading: While excluding inventory from the calculation helps focus on more liquid assets, this can be misleading in industries where inventory is quickly convertible into cash, like retail.
- No Insight into operational efficiency: The Quick Ratio is purely a measure of liquidity. It does not provide insights into a company’s profitability, operational efficiency, or long-term solvency.
To Sum Up
Quick Ratio is an invaluable tool in financial analysis, offering a clear perspective on a company’s short-term liquidity. While it’s a stringent indicator, especially compared to the Current Ratio, understanding its limitations is crucial. It serves as a key financial metric for investors and managers to assess financial stability and make informed decisions.
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FAQs
What is the Quick Ratio?
The Quick Ratio, or the Acid-Test Ratio, is a financial metric that measures a company’s capacity to fulfill its short-term liabilities with its most liquid assets.
How is the Quick Ratio calculated?
The Quick Ratio is calculated by dividing a company’s liquid assets (cash, marketable securities, and accounts receivable) by its current liabilities.
What does a Quick Ratio of 1:1 mean?
A Quick Ratio of 1:1 indicates that a company has just enough liquid assets to cover its current liabilities. It’s considered a benchmark for adequate liquidity.
Why is inventory not included in the Quick Ratio?
Inventory is excluded from the Quick Ratio because it’s not as liquid as cash, marketable securities, or receivables. It may take time to convert inventory into cash.
Is a higher Quick Ratio always better?
Not necessarily. While a higher Quick Ratio suggests strong liquidity, it can also imply that the company may not be using its assets efficiently.
