July 07, 2024
7 mins read
The quick ratio measures a company’s ability to pay short-term liabilities using liquid assets such as cash, marketable securities, and receivables. It excludes inventory from the calculation. Analysts use this ratio to study liquidity and short-term financial strength. A higher quick ratio may indicate that a company can meet its immediate obligations more easily.
The quick ratio is a financial measure used to evaluate a company’s ability to meet its short-term liabilities using its most liquid assets.
These assets usually include cash, marketable securities, and accounts receivable. Unlike some other liquidity ratios, the quick ratio does not include inventory because inventory may take time to convert into cash.
This makes the ratio a stricter test of short-term financial strength. Analysts and investors often review the quick ratio to understand whether a company can cover its immediate obligations without selling inventory.
The ratio is commonly used in financial analysis and company performance reviews. Understanding the quick ratio helps you assess a firm’s liquidity position and its ability to manage short-term financial commitments.
The quick ratio is a metric used to measure a company’s ability to meet short-term liabilities with its most liquid assets. These assets usually include cash, marketable securities, and accounts receivable.
Unlike the current ratio, the quick ratio excludes inventory from the calculation. Inventory may take time to sell and convert into cash, so it is not considered an immediate source for paying liabilities.
Because of this approach, the quick ratio is often called the acid-test ratio. It provides a stricter measure of liquidity compared with some other financial ratios.
Analysts and investors study the quick ratio to understand whether a company can cover short-term obligations without depending on the sale of inventory or additional financing.
Having learnt the meaning of quick ratio, let us explain its formula and take an example to understand it further.
1.Quick Ratio = Quick Assets divided by Current Liabilities.
2.Quick Assets include those assets which can be easily converted into cash, like cash and cash equivalents, marketable securities, and debtors.
3.Current Liabilities predominantly include creditors or accounts payables.
4.Suppose a business has Rs. 50 as cash, Rs. 60 as marketable securities, and Rs. 70 as debtors. In this case, it has Rs. 180 (50 + 60 + 70) as quick assets.
5.Suppose the same business has Rs. 150 as creditors. Then, its quick ratio is 180/150 or 1.2.
Understanding the components of quick ratio can help you gauge a business’s short-term liquidity better. Find below the major components of this ratio:
1.Cash: This is the most straightforward component. If a business has cash, it can certainly use it to pay for its current liabilities. Hence, it is considered as a quick asset.
2.Cash equivalents: These are those assets, which can be easily converted into cash in a short period. For example, treasury bills, commercial paper, bankers' acceptance, certificates of deposits, etc.
3. Marketable securities: If a business has invested in stocks, bonds, or any other security, which can be sold such that the business can receive cash within 90 days of selling, then such assets are called marketable securities.
4. Debtors: This includes a company’s customers who have not yet paid for the products they have purchased from the company.
5.Creditors: This refers to the suppliers of a company from whom it has purchased products but has not paid for them either partly or entirely. For example, companies often purchase raw materials on credit. In such a case, such purchases are shown under accounts payable or creditors.
6.Other current liabilities: If a business has any other current liabilities, which are falling due in a short period of time, then even such liabilities will be considered as a component of current liabilities.
The quick ratio is one of the most important indicators of the short-term liquidity of a company. Here is why:
If a business does not have an adequate quick ratio, it means it does not have enough funds to pay for its current or short-term liabilities. What can it do, then?
In that case, it will have to borrow to meet those obligations, which will further put pressure on its short-term liquidity. Remember that any kind of borrowing will result in an obligation to pay interest. So, borrowing to pay for current liabilities will increase current liabilities. This can become a vicious circle. Besides, if it is facing pressure on its short-term liquidity, lenders may even refuse to lend money to it.
However, if a business has a high enough quick ratio, it means it has more than sufficient funds to pay for its short-term obligations. This means it does not have to borrow to pay current liabilities, which shows the strength of its liquidity position.
The following steps simplify how to calculate quick ratio:
1.First, you need to calculate quick assets. For this, you need to add cash, cash equivalents, marketable securities, and debtors. Let us call it “A.”
2.Second, you need to calculate current liabilities, which include creditors and any other current liabilities. Let us call it “B.”
3.Third, you need to divide “A” by “B” to arrive at the quick ratio. This is how you can arrive at the quick ratio of a company.
4.For data, you can refer to the annual reports of companies, which are uploaded on their websites and that of the Bombay Stock Exchange (BSE).
Feature | Current Ratio | Quick Ratio |
|---|---|---|
| Definition | The current ratio measures a company’s ability to meet short-term liabilities using all current assets. | The quick ratio measures the ability to meet short-term liabilities using only the most liquid assets. |
| Assets considered | Includes cash, receivables, inventory, and other current assets. | Includes only highly liquid assets such as cash, marketable securities, and receivables. |
| Treatment of inventory | Inventory is included in the calculation. | Inventory is excluded because it may not convert into cash quickly. |
| Liquidity measurement | Provides a broader view of short-term financial resources. | Provides a stricter measure of liquidity and immediate payment capacity. |
Additional Read: Current Ratio vs Quick Ratio
Additional read: Difference Between Cash Flow and Fund Flow
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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Quick ratio shows a business’s ability to pay for its short-term obligations in a short period. For quick ratio, inventory and prepaid expenses are excluded from current assets. However, for the current ratio, they are included.
If a company’s quick ratio is less than 1, it means its quick assets are not sufficient to pay for its current liabilities, which can put strain on its resources. Hence, it is important.
1st Step: Calculate quick assets of a company, which equals: Cash and cash equivalents + marketable securities + accounts receivables. Let us call it “A.”
2nd Step: Calculate current liabilities, which equals: Accounts payable + other current liabilities. Let us call it “B.”
3rd Step: Divide “A” by “B” to find out the quick ratio of a company.
Quick ratio is not based on the cash flows of a business. It is based on numbers reported in a company’s balance sheet, which are on an accrued basis.
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