Quick ratio (also known as acid-test ratio and quick asset ratio) compared to current ratio is much more stricter approach to assess entity’s ability to meet short term obligations. Reason for such stricter ratio is that in some situations some current assets are not as liquid as they need to be. For example in construction industry inventory has significant value and significantly long turnover period i.e. not readily convertible to cash. In such cases current ratio fails to provide reasonable measurement basis.
Opposed to current ratio (that consider all types of short term assets including inventory, receivables, prepayments) quick ratio considers only cash and cash equivalents (also known as quick assets) and usually excludes:
- inventory: as its not easy to convert it into cash quickly or at least its not guaranteed that inventory will fetch the cash flow as entity might agree to a sales price lesser than normal or worse lesser than current book value of inventories.
- such assets that can’t be converted to cash like prepayments, tax assets.
For the purpose of quick ratio we are left with cash, marketable securities (short term investments and other such investments that can be sold readily at negligible cost) and receivables. In this case the quick ratio is as follows:
Quick ratio = [Cash + marketable securities + receivables] / Current liabilities
Another quick ratio form which is more common excludes only inventory from current assets and in this case formula will be as follows:
Quick ratio = [Current assets – inventories] / Current liabilities
Analysis and Interpretation
As quick ratio is essentially a variation of current ratio, higher quick ratio means better liquidity position. For instance quick ratio of 2 means entity has 2 dollars of quick assets to cover 1 dollar of short term liabilities. Entity with higher quick ratio may indicate that entity is doing fine as liabilities are mainly covered by “quick assets”.
Though marketable securities can be sold but mostly they are not meant for disposal to pay short term liabilities. Also cash must not be too low or completely zero after obligatory payments. Therefore, having a good quick ratio may also mean that short term liabilities are paid out of recoveries from debtors and other receivables.
But entity must not only have good receivables turnover ratio but also enough volume of receivables to substantially support the current liabilities and for that entity needs to have good inventory turnover ratio. Summing it up we can say good inventory turnover with good inventory turnover entity may have good quick ratio. That is why companies with better quick ratio also have better cash conversion cycle.
On the other hand if quick ratio is too high then it might indicate surplus cash and cash equivalent available with the entity that could have been used for profit maximization. So having unnecessarily high quick ratio is also an inefficiency.
But having low quick ratio is not always a bad sign as entity’s cash inflows are quite promising and creditors trust the entity in this regard therefore not keeping any surplus cash and cash equivalents in which case quick assets are most of the time equal to current liabilities or often lower as entity will be relying on operational cash flows. So to judge entity’s quick ratio one might consider industry average and norms as good starting point for financial analysis.
|cash at bank||55,000|
|cash in hand||35,000|
Required: Calculate quick ratio
Quick ratio = [Current assets – inventory – prepaid rent] / Current liabilities
= [310,000 – 100,000 – 20,000] / 190,000
Quick ratio = [Receivables + marketable securities + cash at bank + cash in hand] / Current liabilities
= [80,000 + 20,000 + 55,000 + 35,000] / 190,000