Understand Quick Ratio - Definition, Components, Importance and Limitations

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Synopsis:

Quick ratio is one of the most important indicators of a company’s short-term liquidity. It helps to understand whether a business can pay for its short-term liabilities from its current assets.

If a business is unable to pay for its current liabilities from its current assets, it may result in a difficult situation, which can require it to borrow. That said, lenders may not provide it with funds because they know that this business is facing short-term liquidity pressure. Hence, quick ratio is an extremely important indicator.

Suppose you have to pay an amount to someone immediately, what will you do if you do not have sufficient funds? You may have to borrow from somewhere, which will put financial pressure on you. This is because when you borrow, you have to pay interest, which may aggravate your problem.

Similarly, businesses have to pay for their short-term obligations on a daily basis. If they do not maintain sufficient funds, their existence can be threatened. Suppose a company is unable to pay its suppliers, why should those suppliers continue their relationship with it? Needless to say, it will harm the company’s reputation, which may take a long time to repair.

Therefore, a company’s short-term liquidity is extremely important and we use a quick ratio to assess it. In this blog, we will talk about the meaning of quick ratio and its components, importance, and limitations. So, read on…

What is Quick Ratio?

Struggling to understand the concept of “Quick Ratio.” Here is an easy way to understand it:

  1. The quick ratio measures a business's ability to pay for its current or short-term liabilities from its current assets, which can be easily converted into cash.

  2. If a business cannot meet its short-term liabilities, then its day-to-day functioning can be severely affected. Therefore, the quick ratio is a crucial measure of the short-term liquidity of a business.

  3. On the other hand, if a business can pay for its current liabilities easily, it means that it has a sound liquidity position.

The Quick Ratio Formula and an Example to Understand it Better

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.

Components of Quick Ratio

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.

Importance of Quick Ratio

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.

Interpretation of Quick Ratio Results

  1. If a business’s quick ratio is more than 1, it means that its quick assets are higher than its current liabilities. Therefore, it can easily pay for its short-term obligations from its quick assets.

  2. If a business’s quick ratio is 1, it means that its quick assets are exactly equal to its current liabilities. Per se, a quick ratio of 1 is fine. However, it is possible that a business sees a decline in its quick assets, which can affect its ability to pay for current liabilities. So, it is advisable to maintain a quick ratio of more than 1.

  3. If a company’s quick ratio is less than 1, it shows that its quick assets are lesser than its current liabilities. This is a matter of concern, which requires that the company arrange for funds somehow to pay for its current liabilities.

How to Calculate Quick Ratio

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).

Current Ratio vs. Quick Ratio

While both current ratio and quick ratio are measures of a company’s short-term liquidity, there are a few important differences between them.

  1. Current ratio is calculated by dividing all current assets of a company by its current liabilities.

  2. However, quick ratio is calculated by dividing all current assets (excluding inventory and prepaid expenses) of a business by its current liabilities.

  3. For quick ratio, inventory is excluded from current assets because inventory cannot be converted into cash for most businesses in a short period. It typically takes a long period for inventory to be sold to realise cash. Hence, it is excluded.

  4. Then, prepaid expenses are also excluded from a company’s current assets to calculate quick ratio because prepaid expenses cannot be used to pay for current liabilities.

  5. Therefore, quick ratio is a more conservative measure of a company’s short-term liquidity than the current ratio. Quick ratio only considers those assets, which can be readily converted into cash.

  6. But, which of these is a better indicator of a company’s short-term liquidity? If you want to assess a company’s ability to pay for its short-term liabilities in an extremely short period (say 3 months or less), then you should consider its quick ratio.

  7. However, if you are assessing a company’s ability to pay for its short-term liabilities in a period longer than 3 months, you can consider its current ratio.

  8. To be on the safer side, you should consider both Current Ratio and Quick Ratio.

Limitations of Quick Ratio 

While being a useful indicator, quick ratio has its limitations, which are listed below:

  • Quick ratio assumes that all debtors will be able to pay equally well. Often, that is not the case. At times, certain debtors do not pay their dues partly or even entirely. Quick ratio does not consider this.

  • Quick ratio does not capture the cash flows of a business. It is based on numbers reported in a company’s balance sheet, which are on an accrued basis.

  • There are businesses, like shopkeepers and retailers, which have a sizable inventory. If we exclude their inventory from current assets, it may not correctly reflect their short-term liquidity because a large part of their inventory can be liquidated quickly.

Conclusion

Now that you have learned what quick ratio is, you should apply it in your financial analysis. While it can reveal interesting insights about a company, it does have some limitations, which are outlined above. So, do keep them in mind.

Besides, using quick ratio alone for a company may not make sense. Therefore, you should use a number of ratios to analyse a company and then make a decision. If you are trading online, you can also find software which calculates quick ratios for you. In that case, you should know how to interpret the values of the quick ratio.

While interpreting quick ratios for a company, always take into consideration the market conditions, which tend to have a huge impact on such ratios.

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.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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Frequently Asked Questions

What is the quick ratio and how is it different from the current ratio?

Answer Field

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.

Why is the quick ratio important for assessing a companys liquidity?

Answer Field

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.

How do you calculate the quick ratio step-by-step?

Answer Field

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.

 

What are the main limitations of using quick ratio for financial analysis?

Answer Field

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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