Also known as the acid-test ratio, the quick ratio is calculated as follows:
(Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
(Current Assets – Inventory) / Current Liabilities
The quick ratio shows companies whether they can cover current liabilities using liquid assets. It’s an important ratio that helps to take a closer look into the financial health of the organization and prevent any cash shortages before they happen. Using the quick ratio, companies can look ahead and decide if additional financing will be needed to pay upcoming debts.
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How is the Quick Ratio Used?
The quick ratio provides a simple answer to the question: “Do we have enough cash to pay short-term obligations?” It compares the value of a company’s liquid assets to the value of current liabilities to make sure that the assets can cover the liabilities.
Companies rely on the quick ratio because it’s a fast and simple way to make sure their cash flow is adequate enough to pay debts and keep the doors open. The quick ratio can reveal potential financial trouble so organizations can react immediately and avoid running into cash shortages. It creates an opportunity for making necessary adjustments such as securing additional funding to cover lapses in liquidity. The goal is to keep the quick ratio in check and maintain positive financial health within the organization.
As an example, Starbucks uses financial ratios in their annual financial reporting. Ratios provide an easy way to visualize how Starbucks is managing their cash. Instead of relying only on their past performance as comparison, Starbucks also provides the ratios from competitors like McDonald’s, the Travel and Leisure sector, and the Customer Service industry. This way, stakeholders can see how Starbucks is performing in the different categories and whether their numbers indicate potential red flags.
What are Current Liabilities?
Current liabilities consist of any debts that must be paid within one year. The largest current liability for most organizations is the balance in accounts payable. Almost all invoices are due within a year, many within 30 to 60 days. Outside of accounts payable, other current liabilities include:
- Short-term debt like bank loans
- Owed income taxes due within a year
- Accounts payable
- Interest payable
- Dividends payable
What are Liquid Assets?
Liquid assets can easily be converted to cash within 90 days without sacrificing the asset’s value. Cash is always a liquid asset, of course. Other liquid assets are those that a company may view as “like cash” and can include accounts receivables due within 90 days and certain investments.
In most cases, inventory is not a liquid asset. Many organizations can’t rely on turning their inventory over within 90 days (without applying steep discounts) and should, therefore, leave it out as a liquid asset. If you’re wondering whether an asset is considered “liquid”, as yourself these questions:
- Is there an established buyer’s market for the asset?
- Are there a large number of readily available buyers?
- Will ownership transfer and cash exchange be quick?
- Can the asset be sold without significant discounts?
Remember that the key factor in what makes an asset considered liquid is its ability to convert to cash within a short timeframe. If it will take longer than 90 days to complete a transaction and be paid for the asset, it shouldn’t be counted as a liquid asset.
Calculation and Results
Remember the two formulas you can use to calculate the quick ratio:
Quick Ratio = (Current Assets – Liabilities) / Current Liabilities
Quick Ratio = (Cash + Marketable Securities + Accounts Receivables) / Current Liabilities
Calculating the quick ratio is simple. Use the appropriate numbers from the most recent balance sheet and plug them into the formula. The magic number is 1. If the result is “1”, that means the company has just enough to cover expenses. The higher the number, the better the company’s financial health. If a company’s result is less than “1”, they may run into financial trouble and have problems meeting their debts in the coming months.
You can think of this number as a dollar figure. It means that the company has $X for every dollar of current liabilities. If a company has a rating of exactly “1”, it means that it has $1.00 for every dollar of current liabilities. If a company has a rating of “0.80”, it means they have $0.80 for every dollar of current liabilities. This creates a very clear picture of a financial outlook. Companies should have at least one dollar of liquid assets for every dollar of current liabilities.
Quick Ratio Limitations
As with any ratio, companies shouldn’t rely solely on that figure and instead need to look at the full financial picture to understand how the company is performing. First, be aware of how accounts receivable can impact this ratio and potentially skew the results. If a company has a large amount of accounts receivable, it may bump up the quick ratio result and make it appear more favorable. However, accounts receivable can’t always be counted on. Sometimes, customers don’t pay on time or they may not pay at all. It may help to use a conservative number, perhaps a percentage of accounts payable, in order to get a better picture.
Also, the quick ratio doesn’t take losses into consideration. If a company experiences a loss, perhaps on an investment, the quick ratio won’t reflect it. Even though the company’s assets are decreasing, the company may still return a favorable result on its quick ratio.
Improving the Quick Ratio
Even if a company’s quick ratio falls below “1”, there is still hope. The simplest way to improve the quick ratio is to increase cash. However, if it were that easy, there wouldn’t be any need to calculate the quick ratio. Here are some other ways to improve the company’s financial outlook:
- Reign in Customer Payment Terms: If any of your customers have terms of 90 days or more, renegotiate them to a shorter term if possible. Having more receivables within the 90-day range will allow you to include them in the quick ratio calculation.
- Reduce Current Liabilities: This could include refinancing debt to reduce payments as well as interest payable.
- Extend Company Payment Terms: Renegotiate the payment terms with vendors to push payments out further. Instead of paying in 30 days, shoot for 60- or 90-day terms to help reduce the accounts payable included in the calculation.
- Watch Expenses: Keeping expenses to a minimum is a great way to improve the quick ratio. Evaluate the company’s upcoming expenses and take action to reduce or put them off when possible.
What About the Current Ratio?
The current ratio formula is as follows:
Current Ratio = Current Assets / Current Liabilities
Companies use the current ratio for similar reasons as the quick ratio; to understand how well a company can cover its short-term obligations. However, the current ratio includes assets that can be turned to cash within one year whereas the quick ratio only includes assets that can be turned to cash within 90 days.
The biggest difference in the two ratios is that the current ratio accounts for inventory but the quick ratio does not. That means the quick ratio offers a more conservative look at a company’s financial health.
The quick ratio provides a snapshot into a company’s financial outlook. It shows how easily an organization will be able to financially handle its upcoming debts and obligations. While it considers all liabilities due within a year, the quick ratio calculation only includes assets that can be easily turned to cash within 90 days. Therefore, it offers leadership a conservative picture of performance. While leaders can use this ratio as a fast way to predict any upcoming cash shortages, they should be looking at the full financial picture before making any quick decisions.