Quick ratio acts as a company’s indicator for its short-term liquidity position, and it measures the ability of the business to discharge its short-term obligations with the liquid assets at its disposal. It includes only such liquid assets which may be converted into cash within 90 days without bearing an adverse impact on its price.
Quick ratio takes into account all kinds of current assets except inventory and prepaid expenses. Inventories usually take a much longer time to be liquidated into cash for meeting the immediate liabilities. Prepaid expenses include all such prospective expenses that may arise, and for which payment has been made in advance.
Such current assets cannot be utilised in order to pay for other liabilities. The ratio seeks to assess the short-term liquidity of a company and leaves out any asset which cannot be easily converted to cash. Hence, the quick ratio is also referred to as an Acid Test as well.
This ratio includes such assets, which can be readily converted to cash. Some examples include marketable securities, accounts receivable, apart from cash. These assets are considered to be “quick assets” because of their easy convertibility into cash.
The formula for measuring quick ratio is mentioned below –
|Quick ratio = (Cash and cash equivalents + Accounts receivable + Marketable securities) / Current liabilities|
When asset break-up is not mentioned in a balance sheet, the following formula should be used –
|Quick ratio = (Current assets – Prepaid expenses – Inventory) / Current liabilities|
Suppose, the quick ratio for a business is 4.5. This would indicate that the business has the repayment capacity of its current liabilities 4.5 times over utilising its liquid assets.
A result of 1:1 is considered to be the ideal ratio of quick ratio.
Consider that a clothing boutique is applying to a financial institution for a loan in order to remodel its store. A lender would need to compute the quick ratio and ask for the balance sheet from the store owner. The balance sheet is illustrated below.
|Accounts receivable||Rs. 5,000|
|Investments in stocks||Rs. 1000|
|Prepaid taxes||Rs. 500|
|Current liabilities||Rs. 15,000|
|Quick ratio = (10,000 + 1000 + 5000) / 15000|
= 16000 / 15000
The quick ratio of the business is 1.07, which indicates that the owner can pay off all the current liabilities with the liquid assets at the disposal and still be left with a few assets.
Even though both the current ratio and quick ratio measures the financial health of a company, there are certain differences between the two.
Current ratio relates to measuring the ability of a company to pay its short-term or current liabilities with that of its short-term assets such as inventory, cash, and receivables. Current assets on the balance sheet of a company will represent all such assets that may be converted into cash within a period of 1 year. Current assets cover accounts receivable, inventory, marketable securities, cash and cash equivalents, and prepaid expenses.
A company’s current liabilities include accounts payable, short-term debt along accrued liabilities, among others.
Current ratio is calculated in the following manner –
|Current Ratio = Current Assets / Current Liabilities|
If the current ratio of a company amounts to less than 1, creditors can perceive the business as a risk. This is because the ratio indicates that the current assets held by a company are insufficient to meet its current liabilities. Thus, it is incapable of discharging all short-term obligations.
Quick ratio, on the other hand, omits inventory and other such assets, which cannot be converted into cash quickly. In most cases, inventories take a much longer time to be liquidated. For converting inventories to cash, it will have to be sold to the customer. In the course of the collection process, customers may also purchase other inventories on credit, which may further delay the payment. Due to these factors, inventories are excluded from the quick ratio as opposed to the current ratio.
Quick ratio assesses the dollar amount of the various liquid assets at the disposal of a company against the equivalent amount of its existing liabilities. A company’s current liabilities include its obligations or debts, which must be cleared within the year.
Such debts or obligations are discharged by liquid assets held by the company. Liquid assets involve such assets which may be converted into cash with negligible impact to its price in the open market.
It is precisely an indicator of a company’s ability or limitation in discharging its debts and obligations. A healthy liquidity ratio is taken as the competence of the organisation and assures healthy business performance which may eventually lead to the sustainable growth of an organisation. A company’s lenders, suppliers and investors rely on quick ratio to determine if it has enough liquid assets for discharging its short-term liabilities.
Ratio of 1:1 is held to be the ideal quick ratio indicating that the business has in its possession enough assets which may be immediately liquidated for paying off the current liabilities.
If it is less than 1, the low quick ratio will not allow the company to pay off its current liabilities outstanding in the short term entirely. However, if the ratio is higher than 1, the company retains such liquid assets to discharge its current liabilities immediately.