The quick ratio, also known as acid test ratio, measures whether a company’s current assets are sufficient to cover its current liabilities. A quick ratio of one-to-one or higher indicates that a company can meet its current obligations without selling fixed assets or inventory, indicating positive short-term financial health.
How the Quick Ratio Works
The quick ratio is a liquidity ratio, like the current ratio and cash ratio, used for measuring a company’s short-term financial health by comparing its current assets to current liabilities. A company’s stakeholders, as well as investors and lenders, use the quick ratio to measure whether it can meet current short-term obligations without selling fixed assets or liquidating inventory.
Quick Ratio Formula
The quick ratio formula takes a company’s current assets, excluding inventory, and divides them by its current liabilities. Current assets include liquid assets like cash and cash equivalents while current liabilities include short-term liabilities like accrued compensation and payroll taxes.
The quick ratio formula is:
Quick Ratio = Cash + Cash Equivalents + Marketable Securities + Accounts Receivable (A/R) / Current Liabilities
Current Assets
Current assets include any balance sheet assets convertible to cash within 90 days. Liquid assets include cash and cash equivalents. A/R and marketable securities are considered current assets because they are generally understood to be convertible to cash within 90 days.
Some examples of current assets are:
- Cash: Cash consists of funds held in checking accounts, savings accounts, any coins or currency, petty cash, and any money orders and bank drafts.
- Cash equivalents: Cash equivalents highly liquid, short-term investment securities including treasury bills, money market funds, short-term government bonds, commercial paper, and securities.
- A/R: A/R include a company’s outstanding invoices or money the company has yet to collect from customers in exchange for delivered goods or services. A/R are typically due within 90 days, making them highly convertible to cash.
What’s Not Included in Current Assets
Any assets that are not typically convertible to cash within 90 days are excluded from current assets and, therefore, don’t impact a company’s quick ratio. This includes inventory, as it is assumed it will be difficult to sell off all inventory within 90 days without discounting and potentially selling at a loss. All other excluded assets are considered fixed assets, which includes any assets that are not sold or otherwise consumed by a business during normal operations, such as property, equipment, and vehicles.
Some examples of assets not included in current assets are:
- Property: Property includes any buildings, land, or other real property held by a business.
- Equipment: Equipment includes any machinery, technology such as computers and servers, and other equipment not considered a part of the company’s inventory.
- Vehicles: Vehicles are any cars, trucks, or other titled vehicles owned by a company and not considered a part of its inventory.
Current Liabilities
Current liabilities include all short-term financial obligations that a company must pay immediately or within one year. Included are liabilities like short-term loans, current maturities of long-term debt, accounts payable (A/P), payroll, and taxes.
Some examples of current liabilities are:
- A/P: A/P are any obligations to pay off short-term debt to creditors, vendors, and suppliers.
- Taxes: Taxes include sales taxes, income taxes, and payroll taxes.
- Payroll: Payroll includes any pay currently owed to employees, including salaries, wages, bonuses, and commissions.
- Loans: Examples of current loan liabilities are any short-term loans or current maturities of long-term debts.
What’s not Included in Current Liabilities
Any long-term financial obligations that are not payable within one year are excluded from current liabilities, for example, long-term debt like commercial real estate loans, Small Business Administration (SBA) loans, and most business debt consolidation loans.
How to Interpret Quick Ratio Results
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 one-to-one demonstrates that a company has sufficient current assets to meet 100% of its current liabilities while a ratio less than one-to-one indicates that a company will be unable to meet its current liabilities without increasing sales, selling off fixed assets or inventory, or raising capital some other way.
What Is a Good Quick Ratio?
Whether a company has a strong quick ratio depends on the type of business and its industry. 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.
It is generally understood that a quick ratio of at least one-to-one is desirable, with the ideal target for a company’s quick ratio falling somewhere between 1.2-to-1 and 2-to-1. Anything below one indicates a company will have difficulty meeting current liabilities while anything over two may indicate that a company is not investing its current assets aggressively.
Why the Quick Ratio Is Important
The quick ratio provides a conservative overview of a company’s financial well-being and helps investors, lenders, and company stakeholders to quickly determine its ability to meet short-term obligations. Financial institutions will 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 well-being, and it is 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.
Examples of Other Liquidity Ratios
Using multiple ratios to understand the current standing of a business is always advised. Small business owners should consider current and cash ratios as well because both of them are popular alternatives and work in conjunction with the quick ratio.
Quick Ratio vs Current Ratio
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.
The quick ratio only counts as current assets those which 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.
Quick Ratio vs Cash Ratio
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 is 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 should not be counted among liquid assets as to do so may artificially inflate a company’s ability to meet its debt obligations in the short-term. It is sometimes criticized due to its conservative measurement of stability and does not account for businesses that are efficient at selling through inventory and collecting on A/R.
Pros and Cons of Using the Quick Ratio
The quick ratio is one of several liquidity ratios and just one way of measuring a company’s short-term financial health. Among its positives are its simplicity as well as its conservative approach. Among its negatives, it cannot provide accurate information regarding cash flow timing, and it also may not properly account for A/R values.
Pros of the Quick Ratio
- Simplicity: The quick ratio helps the company understand the level of its liquidity, helping them gauge the short-term financial strength of their business.
- Conservative approach: Because inventory is not included in the quick ratio, it is considered a conservative method of measuring the company’s liquidity when compared to the current ratio.
Cons of the Quick Ratio
- Timing of cash flows: The quick ratio doesn’t provide accurate information about the timing of cash flows.
- A/R: The quick ratio assumes that a company’s A/R can be readily collected anytime, which is always the case. Additionally, the value A/R may be lower than book value due to early payment discounts and other arrangements.
While the acid test can be a great tool for companies attempting to gauge their short term health, as well as investors, lenders, and other partiers, due to its shortcomings, using the ratio on a standalone basis may not be sufficient to analyze the exact liquidity position of the company.
How to Improve Quick Ratio
A company with a higher quick ratio is considered to be more financially stable than those with a lower quick ratio. A quick ratio greater than one is considered “healthy.” Having a healthy quick ratio is important for companies themselves as well as their creditors, lenders, investors, capitalists, and other stakeholders. Businesses should always keep their quick ratio properly managed.
Three of the most common ways to improve the quick ratio are to increase sales and inventory turnover, improve invoice collection period, and pay off liabilities as early as possible.
1. Increase Sales & Inventory Turnover
One of the most common methods of improving liquidity ratios is increasing sales. Methods like discounting, increased marketing, and incentivizing sales staff can all be used to increase sales that, in turn, will increase the turnover of inventory. As discussed earlier, inventory is excluded from calculating the quick ratio. This means that for inventory to become a more liquid asset, it should first be converted into cash through actively selling it.
2. Improve Invoice Collection Period
Reducing the collection period of A/R has a direct and positive impact on a company’s quick ratio. When the collection period is shorter, it can help boost a company’s incoming cash flow. The probability of encountering long-term debtors, sticky debtors, and bad debts is also reduced. Setting clear invoice terms at the beginning of any transaction as well as making an active collection effort will directly impact a company’s quick ratio.
3. Pay Off Liabilities as Early as Possible
Keeping the company’s liabilities under control is essential to improving the quick ratio. 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.
Bottom Line
Although quick ratio does not 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 or not 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.
