The quick ratio, also known as acid test ratio, measures the liquidity of a company. It calculates the proportion of a company’s current assets to its current liabilities. The quick ratio is used to determine a company’s ability to meet short-term obligations with liquid assets that can be easily converted into cash.
The quick ratio measures liquidity by dividing a company’s short-term assets with its short-term obligations. Current assets include cash, cash equivalents, marketable securities, and accounts receivables that are due in 90 days or less. Current liabilities include all short-term liabilities on a company’s balance sheet.
Quick Ratio Formula
Calculating the quick ratio is relatively easy. We’ll walk you through the formula and define each component below.
The quick ratio formula is:
(Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Total Current Liabilities
Cash equivalents are highly liquid, short-term investment securities that have a typical maturity of three months or less. This type of investment is unrestricted, making it available for immediate use. Cash equivalent funds include treasury bills, money market funds, short term government bonds, commercial paper, and securities.
Marketable securities represent a company’s short-term investments that are available for sale. These securities can typically be converted into cash within the next 60 to 90 days. Usually, marketable securities are traded on an open market at a set price to readily available buyers.
Accounts receivable is the company’s outstanding invoices. It is the money that company has to receive from their customers in exchange for delivered goods or services. Accounts receivables are usually due in 90 days or less and typically have a 90% collection rate, making them liquid.
Inventory is not included in the measurement because it’s generally considered to be less liquid. For this reason, the quick ratio is believed to be a more conservative version of the current ratio, making it a better basis to measure how much these assets can cover in case the company will have financial difficulties.
Current liabilities are debts and obligations due within 12 months. Current liabilities are debt obligation that will appear on a business’s balance sheet. Current liabilities would include short term loans, lines of credit, accounts payable, accrued liabilities, and other short term debt. It does not include long term debt like commercial real estate loans, SBA loans, or most business debt consolidation loans.
Ideally, the company’s quick ratio should be 1:1 or higher. A quick ratio of 1+ means that a company has sufficient liquid assets to meet its short-term financial obligations. A low quick ratio below 1 means that a company has more current liabilities than assets and it might be an indicator that the company is in financial distress.
Why is the Quick Ratio Important?
The quick ratio is important because it provides a conservative overview of the company’s financial standing. It tells several things about a company, especially its ability to pay short-term obligations. The quick ratio determines whether the company has enough resources to meet its accounts payable, operating expenses, and other short-term obligations.
Both businesses and creditors consider the quick ratio an important way of measuring a company’s liquidity. For example, most financial institutions will often look at the company’s quick ratio when deciding whether or not to extend credit. Generally, companies with higher the quick ratio are typically considered better borrowers compared to companies with a lower quick ratio.
While the quick ratio is important and helpful when it comes to assessing the company’s financial status, small businesses don’t normally use this method to measure liquidity. Rather, quick ratio is often used by Chief Financial Officers and corporate finance professionals. It is also used by investment analysts that cover public companies.
Pros and Cons of Using the Quick Ratio
The quick ratio is just one way of measuring the company’s liquidity and short-term financial health. Using the quick ratio to determine the company’s ability to settle its current short-term liabilities therefore has its benefits and drawbacks.
Pros of the Quick Ratio:
- The quick ratio helps the company understand the level of its liquidity, helping them gauge the short-term financial strength of their business.
- 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.
- The quick ratio eliminates business valuation issues by removing inventory, making it the more preferred method to measure liquidity.
Cons of the Quick Ratio:
- The quick ratio doesn’t provide accurate information about the timing of cash flows.
- The quick ratio assumes that a company’s accounts receivables can be readily collected anytime, which is not normally the case for many companies.
- The total actual amount of accounts receivable received may be slightly below book value thanks to things like special discounts for early payments.
- Using this ratio on a standalone basis may not be sufficient to analyze the exact liquidity position of the company.
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. A quick ratio greater than 1 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.
Below are the top 3 ways to improve the quick ratio:
1. Increase Sales & Inventory Turnover
Increasing sales can improve your inventory turnover, which can increase a company’s cash on hand. And because cash is the most liquid asset, the better the company is at increasing its sales or improving inventory turnover, the more cash will be available for the company to meet its short-term obligations.
As discussed earlier, inventory is excluded from calculating the quick ratio. This means that in order 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 accounts receivable will have 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 are also reduced.
We mentioned that one of the drawbacks of the quick ratio is that not all accounts receivable can be readily collected. In order to ensure the liquidity of accounts receivable, the invoice terms have to be made clear right at the beginning of the transaction. Also, active collection effort from the company is recommended.
3. Pay Off Liabilities as Early as Possible
Keeping the company’s liabilities under controlled 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 through paying off creditors faster whenever possible and reducing the repayment terms for business loans.
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. It’s therefore important to monitor your quick ratio and ensure that your finances are under control.