Quick Ratio Explained With Formula and Examples

The quick ratio holds significant importance in corporate and organizational finance, as it helps assess a company’s ability to promptly and flexibly meet its short-term obligations without relying on inventory. Let’s explore this financial metric in detail in the following article!

What is the quick ratio?

The quick ratio, also known as the Acid test ratio or Liquidity ratio, is an important ratio in corporate financial analysis that reflects a company’s ability to meet its short-term obligations without relying on the sale of inventory. This metric helps assess the company’s immediate liquidity and overall financial health, particularly in risk management and investment decision-making.

>>See more:

How to calculate quick ratio

The quick ratio formula

As its name indicates, the quick ratio is equal to the quick assets of a company divided by its current liabilities. The formula for the acid test ratio is as follows:

Quick ratio = Liquid assets ÷ Current liabilities

To calculate the liquid assets of a company, you can use any of the following two formulas:

Liquid assets = Cash and cash equivalents + Marketable securities + Accounts receivable

Liquid assets = Current assets – Inventory – Prepaid expenses

Example using quick ratio

Let’s say you own a company that has $10 million in cash and cash equivalents, $30 million marketable securities, $15 million of accounts receivable, and $22 million of current liabilities. To calculate the quick ratio, divide current liabilities by liquid assets. In this case:

Quick assets = ($10 million cash + $30 million marketable securities + $15 million accounts receivable)
Current liabilities = $22 million
Acid test ratio = $55 million / $22 million = $2.5 million.

=> The company’s acid test ratio is 2.5, meaning it has more than enough capital to cover its short-term debts.

What the quick ratio means for the business

The quick ratio is used to evaluate a company’s ability to meet its short-term liabilities using highly liquid assets such as cash, cash equivalents, and short-term receivables.

If the quick ratio value is high, it indicates that the company has sufficient capacity to promptly pay off its short-term debts. This reflects a strong liquidity position, financial stability, and effective cash flow management.
Conversely, when the quick ratio is low, it means the company’s liquid assets are limited. This suggests potential difficulty in settling short-term obligations promptly, thereby increasing liquidity risk.
Typically, the optimal ratio between quick assets and short-term liabilities is 1:1, meaning the company possesses enough liquid assets to immediately cover all short-term debts without relying on inventory sales or other assets.

In summary, the acid test ratio is a crucial metric that helps managers and investors assess a company’s ability to respond to short-term financial obligations, enabling them to make informed business and investment decisions.

The acid test ratio is an important metric for evaluating a company’s short-term financial health.

What is a good quick ratio?

A good acid test ratio is above 1. If the ratio is below 1, a company might have trouble paying its current liabilities.

However, an extremely high quick ratio isn’t necessarily a good sign, since it may indicate the company is sitting on a significant amount of capital that could be better invested to expand the business.

The optimal acid test ratio for a business depends on a number of factors, including the nature of the industry, the markets in which it operates, its age and its creditworthiness. For example, an established business with strong supplier relationships and a good credit history may be able to operate with a significantly lower acid test ratio than a startup because it’s more likely to obtain additional financing at low interest rates and/or negotiate credit extensions with suppliers in the event of an emergency.

Limitations of the quick ratio

Although the quick ratio is a useful metric, it also has several limitations that businesses should be aware of:

Does not fully reflect actual cash flow: The quick ratio is based on the book value of current assets but does not consider their real liquidity. For instance, some receivables may take a long time to collect or even risk being uncollectible, which reduces the company’s actual liquidity.
Does not account for industry differences: Companies in different industries operate under distinct business models, leading to variations in the “ideal” acid test ratio. For example, a technology firm may have a high quick ratio (1.5–2.0) due to large cash reserves, while a manufacturing company might have a lower ratio (0.8–1.2) because it invests heavily in inventory.

Does not measure operational efficiency: A company with a high acid test ratio is not necessarily efficient. If it holds excessive cash without reinvesting to foster growth, its potential profitability may decline.
Does not reflect long-term solvency: The quick ratio focuses solely on short-term liabilities and does not evaluate a company’s ability to meet long-term obligations. Therefore, it should be used alongside other metrics such as the current ratio or debt-to-equity ratio to provide a more comprehensive assessment of financial health.

Difference between current ratio and quick ratio

Although the two are often confused with one another, the quick ratio is different from the current ratio. Here is a summary of the key differences:

Particulars	Quick Ratio	Current Ratio
Meaning	Measures a company’s capacity to repay its short-term obligations with its most liquid assets	Measures a company’s capacity to repay its short-term obligations with all its current assets
Formula	(Cash + Marketable securities + Accounts receivable) ÷ Current liabilities	Total current assets ÷ Current liabilities
Components	Includes cash, marketable securities and accounts receivables	Includes cash, marketable securities, accounts receivables, inventory and other current assets
Inventory	Excludes inventory from the calculation	Includes inventory in the calculation
Purpose	Provides a more stringent test of liquidity by excluding inventory, which may not be readily convertible to cash	Offers a broader overview of a company’s liquidity by including all the assets that can be converted to cash within a year
Sensitivity	More sensitive to changes in inventory levels and accounts receivables	Less sensitive to changes in inventory and other current assets

Conclusion

The above provides all the essential information related to the quick ratio. We hope this article has answered your questions. Follow Tipstrade.org to stay updated with the latest articles on financial knowledge!

Financial ratios