See Also:
Balance Sheet
Working Capital
Current Ratio Analysis
Financial Ratios
Download ToolQuick Ratio Definition
The quick ratio, defined also as the acid test ratio, reveals a company's ability to meet short-term operating needs by using its liquid
assets. It is similar to the current ratio, but is considered a more reliable indicator of a company’s short-term financial strength. The difference between these two is that the quick ratio subtracts inventory from
current assets and compares the quick asset to the
current liabilities. Similar to the current ratio, value for the quick ratio analysis varies widely by company and industry. In theory, the higher the ratio is, the better the position of the company is. However, a better benchmark is to compare the ratio with the industry average.
Quick Ratio Explanation
Quick ratios are often explained as measures of a company’s ability to pay their current debt liabilities without relying on the sale of inventory. Compared with the current ratio, the quick ratio is more conservative because it does not include inventories which can sometimes be difficult to liquidate. For lenders, the quick ratio is very helpful because it reveals a company’s ability to pay off under the worst possible condition.
Although the quick ratio gives investors a better picture of a company’s ability to meet current obligations the current ratio, investors should be aware that the quick ratio does not apply to the handful of companies where inventory is almost immediately convertible into cash (such as retail stores and fast food restaurants).
Quick Ratio Formula
The current ratio formula is:
Current ratio = (Current assets – Inventories) / Current liabilities
Or = Quick assets / Current liabilities
Or = (Cash +
Accounts Receivable + Cash equivalents) / Current liabilities
Quick Ratio Calculation
Quick ratio calculation is a useful skill for any business that may face cashflow issues. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. It normally includes cash, marketable securities, and some accounts receivables.
Current liabilities represent financial obligations that come due within one year. It normally included
accounts payable, notes payable, short-term loans, current portion of term debt, accrued expenses and taxes.
Example: a business has $5,000 in current assets, $1,000 in inventories and $2,500 in current liabilities.
Quick ratio = (5,000 – 1,000) / 2,500 = 1.6
Since we subtracted current inventory, it means that for every dollar of current liabilities there are $1.6 of easily convertible assets.
Quick Ratio Example
Suzy has started a boutique-style bakery which is mainly servicing customers who desire wedding cakes. Suzy, who works in a trade which she is truly passionate about, is by no means an expert in financial statements. She is, however, an expert in the operations of her business. She knows that if she wants to scale, something that her customers are driving her to as much as her own desires for financial success, she needs a partner who can provide the business expertise. About the time she realizes this Suzy meets Monica, an experienced restauranteur. The two women quickly develop a rapport. Suzy learns that Monica is looking for a new deal and communicates her needs over lunch. They resolve, after a testing period, to support each other by applying their expertise to Suzy's business. The two women become partners.
Monica knows that lack of cash is one of the main reasons that causes any business, especially in food-service, to close doors. As Monica takes her initial look at the financial statements of the business she keeps this in mind.
Monica wants to know if the company can pay its debts. Due to the fact that the business desperately needs all inventory to continue scaling, she resolves to use quick ratio vs current ratio calculation. Since there is no quick ratio accounting calculator, she performs this calculation:
If:
Current Assets = $5,000
Inventory = $1,000
Current Liabilities = $2,500
Quick ratio = (5,000 – 1,000) / 2,500 = 1.6
This means that for every dollar of current liabilities there are $1.6 of easily convertible assets.
This is a major relief to Monica. Finishing her analysis of the company statements Monica feels very confident. As long as employee turnover remains the same the two women have avoided two of the most important issues a business could face.
Resources
For statistical information about industry financial ratios, please go to the following websites:
www.bizstats.com and
www.valueline.com.