This article is part of a larger series on Business Financing.
The quick ratio is also known as the acid test ratio. It measures whether a company’s current assets are sufficient to cover its current liabilities. The quick ratio formula takes a company’s current assets, excluding inventory, and divides them by its current liabilities. A quick ratio of 1.0 or higher indicates that a company can meet its current obligations without selling fixed assets or inventory, indicating positive short-term financial health.
How to Calculate the Quick Ratio
The quick ratio is a liquidity ratio, such as the current ratio and cash ratio and is used by a company’s stakeholders, investors, and lenders. The quick ratio formula is:
Quick Ratio = Cash + Cash Equivalents + Marketable Securities + A/R / Current Liabilities
As an example, a quick ratio of 1.4 would indicate that a company has $1.40 of current assets available to cover each $1 of its current liabilities.
Current assets include any balance sheet assets convertible to cash within 90 days. Some examples of current assets are:
- Cash: Cash consists of funds held in checking, savings, any coins or currency, petty cash, and any money orders and bank drafts.
- Cash equivalents: Cash equivalents include short-term investments, such as treasury bills, money market funds, government bonds, commercial paper, and any other marketable securities that can be liquidated easily.
- Accounts receivable (A/R): This includes a company’s outstanding invoices, as well as money the company has yet to collect from customers, in exchange for delivered goods or services. These are typically due within 90 days, making them highly convertible to cash.
What’s Not Included in Current Assets
Any assets that aren’t typically convertible to cash within 90 days are excluded from current assets and, therefore, not included in a company’s quick ratio. Some examples are:
- Property: Any buildings, land, or other real property held by a business aren’t factored in the quick ratio.
- Inventory: This is excluded as it’ll be difficult to sell inventory off within 90 days without discounting and potentially selling at a loss.
- Equipment: Any machinery, technology, such as computers and servers, and other equipment not considered a part of the company’s inventory is excluded.
- Vehicles: Cars, trucks, or other titled vehicles owned by a company and not considered a part of its inventory.
Current liabilities include all short-term financial obligations that a company must pay immediately, or within 90 days. Some examples of current liabilities are:
- Accounts payable (A/P): A/P are any obligations to pay off short-term debt to creditors, vendors, and suppliers.
- Taxes: Taxes include sales tax, income tax, and payroll tax.
- Payroll: Payroll includes any salaries, wages, bonuses, and commissions owed to employees.
- Loans: Examples of loans include any short-term loans or long-term debts with maturities within one year.
What’s Not Included in Current Liabilities
Any long-term financial obligations that aren’t payable within one year are excluded from current liabilities. This includes debt, such as commercial real estate loans, Small Business Administration (SBA) loans, and most business debt consolidation loans.
Why the Quick Ratio Matters
The quick ratio provides a conservative overview of a company’s financial well-being. It helps investors, lenders, and company stakeholders quickly determine the ability to meet short-term obligations. Financial institutions often measure a company’s quick ratio when determining whether to extend credit while investors may use it to determine whether to invest capital, as well as how much to invest.
Both businesses and bankers consider the quick ratio an important tool to measure a company’s financial wellbeing, and it’s also generally employed by corporate financial professionals as well as investment analysts to assess the health of publicly traded companies. Small businesses can also benefit from using the quick ratio, as well as other liquidity ratios, to assess financial health.
What Is a Good Quick Ratio?
In general, the higher the quick ratio is, the higher the likelihood that a company will be able to cover its short-term liabilities. A ratio greater than 1.0 demonstrates that a company has sufficient current assets to meet current liabilities, while a ratio less than 1.0 indicates that a company will be unable to meet its current liabilities without increasing sales, selling off fixed assets or inventory, or raising capital.
Additionally, the quick ratio of a company is subject to constant adjustments as current assets, such as cash-on-hand, and current liabilities, such as short-term debt and payroll, will vary. As a result, many companies try to keep their quick ratio within a certain range, rather than pegged at a particular number.
Whether a company has a strong quick ratio depends on the type of business and its industry but, for many industries, the ideal quick ratio ranges between 1.2 and 2.0. Anything below 1.0 indicates a company will have difficulty meeting current liabilities while a ratio over 2.0 may indicate that a company isn’t investing its current assets aggressively.
How to Improve the Quick Ratio
A company with a higher quick ratio is considered to be more financially stable than those with a lower quick ratio. Having a healthy quick ratio is important for companies and their creditors, lenders, investors, and other stakeholders. Businesses should always work to keep their quick ratio managed properly.
Three of the most common ways to improve the quick ratio are:
- Increase sales & inventory turnover: Discounting, increased marketing, and incentivizing sales staff can all be used to increase sales, which subsequently will increase the turnover of inventory. Since inventory is excluded from quick ratio calculations, selling your inventory would yield more cash, which is included in the quick ratio.
- Improve invoice collections: Reducing the collection period of A/R has a positive impact on a company’s quick ratio. A shorter collection period can help boost a company’s incoming cash flow and will also reduce the odds of encountering long-term debtors and bad debts. Setting clear invoice terms at the beginning of any transaction as well as making an active collection effort will also help.
- Pay short-term liabilities quickly: Managing your company’s liabilities is essential. Current liabilities are in the denominator of the quick ratio, and keeping them low will put your business in a better position. This can be achieved by paying off creditors faster whenever possible and reducing the repayment terms for business loans.
Examples of Other Liquidity Ratios
Liquidity ratios are calculations that examine a company’s ability to cover short-term obligations. In addition to their use by company stakeholders to measure the financial health of a business, they can be used by investors, as well as creditors when determining whether to offer financing. Besides the quick ratio, the current ratio and cash ratio are also used.
The current ratio, sometimes known as the working capital ratio, is a popular alternative to the quick ratio. The two ratios differ primarily in the definition of current assets. Current assets are typically any assets that can be converted to cash within one year, which is how the current ratio is defined.
Meanwhile, the quick ratio only counts as current assets that can be converted to cash in about 90 days, and specifically excludes inventory. A common criticism of the current ratio is that it may underestimate the difficulty of converting inventory to cash without selling the inventory below market price, and potentially at a loss.
The cash ratio is another liquidity ratio which is commonly used to assess the short-term financial health of a company by comparing its current assets to current liabilities. It’s considered the most conservative of like ratios as it excludes both inventory and A/R from current assets.
The cash ratio is based on the assumption that both inventory and A/R may be difficult to collect on and shouldn’t be counted among liquid assets, as to do so may inflate a company’s ability to meet its debt obligations artificially in the short term. Sometimes, it’s criticized due to its conservative measurement of stability and doesn’t account for businesses that are efficient at selling through inventory and collecting on A/R.
Although the quick ratio doesn’t provide the most accurate picture of the company’s overall financial health, it can help determine the company’s short-term financial position. It measures whether the company’s current assets are sufficient to cover its short-term financial obligations. Therefore, it’s important to monitor your quick ratio and ensure that your finances are under control.