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What is Quick Ratio?
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 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, quick ratio is also referred to as an Acid Test as well.
Calculation of Quick Ratio
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 its 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.
Quick Ratio Example
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.
Difference Between Current Ratio and Quick Ratio
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
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 which 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 with 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
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.
Importance of Quick 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 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.
Limitations of Quick Ratio
- Quick ratio on its own may not suffice in analysing liquidity of a company. The analysis must undertake a comparison with competitors as well as existing industry standard since the ratio is entirely a mathematical value which does not provide an estimation of assets and liabilities under calculation. It should also take into consideration the cash flow ratio or the current ratio for determining an accurate and comprehensive estimation of the liquidity of a company.
- The ratio excludes inventory from the calculation, which is counterproductive for companies with high inventory. For example, supermarkets have high inventory which is easily valued at a marketable price. In such a situation, if the ratio only depends on cash or cash equivalent, results of would lack accuracy.
- It does not take into account any period for payments. It is entirely possible that the accounts receivables eventually become bad debt, which cannot be recovered or that recovery may happen after a long delay. Such a situation would adversely impact the liquidity of a company which is not reflected in the Quick Ratio. The ratio also presumes that accounts receivables are readily available within the decided time period.
- Quick ratio enables the company to make future projections, but it is calculated on past data, which may lead to such projections being fallacious. For instance, a company may have a low quick ratio. However, the management may retain a robust relationship with its suppliers and banks which would enable it to meet its liabilities as effectively as a company with a high quick ratio.