If you are planning to invest in a company over the long term, its profitability is not the only aspect that you need to evaluate. The companyâ€™s liquidity is also important. A high level of liquidity indicates that the company can pay its debts and other liabilities without raising more capital or availing of more loans. This, in turn, strengthens a companyâ€™s financial health.Â
So, how do you measure the liquidity of a company? One way is to use theÂ quick ratio. In this article, we discuss theÂ meaning of the quick ratio, how it works, theÂ quick ratio formula and how toÂ calculate the quick ratio, among other things.Â
TheÂ quick ratio is an easy way to measure how much short-term liquidity a company possesses. It evaluates if a company has enough quick assets or near-cash assets to meet its current liabilities. These are essentially assets that can easily be converted into cash.Â
If a companyâ€™s quick assets are adequate, it need not resort to additional loans or newly raised capital to meet its short-term liabilities and financial obligations. This strengthens the companyâ€™s books of accounts and acts as a positive sign for investors.Â
Since theÂ quick ratio helps you instantly test if a company has sufficient liquidity, it is also known as the acid test ratio. Before you invest in a company, ensure that you evaluate theÂ quick ratio along with other keyÂ financial ratios to assess its financial strength and position.Â
Investors often simply look into a companyâ€™s debt levels, its profitability and the assets it holds before making an investment decision. While these are undoubtedly important aspects, they are not the only factors that you must consider. You must also check if the company has enough liquidity. This is important because low liquidity can lead to mounting debt levels for a company â€” which is rarely a good sign over the long term.Â
TheÂ quick ratio helps you evaluate this aspect. It tells you if a company has reasonable liquidity or if it is having issues with its short-term cash availability. In other words, it tells you if the company is capable of paying off its short-term liabilities without resorting to external funding.Â
Now that you have seen theÂ meaning of the quick ratio and how it works, let us discuss how toÂ calculate the quick ratio. From its definition, you know that this ratio compares the quick assets of a company with its current liabilities. So, theÂ quick ratio formula is:
Quick ratio = Quick assets Ã· Current liabilitiesÂ
Generally, the quick assets of a company include cash, cash equivalents, net accounts receivables and marketable securities. These are current assets that are easy to convert to cash, unlike inventory and prepaid expenses. So, you can find the quick assets using any of the formulas shown below:
Quick assets = Cash + Cash equivalents + Net accounts receivables + Marketable securitiesÂ
Or
Quick assets = Total current assets â€” Inventory â€” Prepaid expensesÂ
Once you find the value of the quick assets, you can plug it into theÂ quick ratio formula and use it toÂ calculate the quick ratio.Â
At first glance, it is evident from theÂ meaning of the quick ratio that it consists of two components â€” namely, quick assets and current liabilities. However, what do each of these components include? Letâ€™s find out.
Quick assets form a part of a companyâ€™s current assets. While current assets can generally be converted into cash within a year, the conversion cycle for quick assets is even shorter, often within 90 days or so. So, inventory and prepaid expenses, which do not meet this criterion, are not considered quick assets.Â
Some of the most common examples of quick assets include the following:
Unlike current assets, which are not entirely considered in theÂ quick ratio, all the current liabilities of a company are taken into account. This number can be found in a companyâ€™s balance sheet. The ratio uses the total current liabilities because it assumes that all these debts have a short-term due date. Examples of current liabilities include salaries payable, wages due, immediate payments due on long-term loans, accounts payables and any tax payments due.Â
Having seen theÂ meaning of the quick ratio and its formula, you may now want to explore the process of calculating this ratio. Let us consider an example to make this clearer for you.Â
Say there are two companies with the following financial parameters. The table below shows you how their quick ratios vary.
Particulars | Company 1 | Company 2 |
Cash | Rs. 50,000 | Rs. 60,000 |
Cash equivalents | Rs. 1,00,000 | Rs. 80,000 |
Net accounts receivables | Rs. 2,00,000 | Rs. 3,50,000 |
Marketable securities | Rs. 40,000 | Rs. 10,000 |
Total quick assets (A) | Rs. 3,90,000 | Rs. 5,00,000 |
Current liabilities (B) | Rs. 6,50,000 | Rs. 4,30,000 |
Quick ratio (A Ã· B) | 0.60 | 1.16 |
Once you find theÂ quick ratio of a company, you need to analyse what it means. This is why it is important to know how to interpret the ratio. Broadly, the higher the ratio, the more a companyâ€™s liquidity is. So, in our example, company 1 has lower liquidity than company 2.Â
Here are some general thumb rules you can use to understand what different values of theÂ quick ratio mean.
TheÂ quick ratio is important for investors due to various reasons. Its top advantages include the following:
TheÂ quick ratio gives a clear picture of a companyâ€™s short-term liquidity by focusing on its most liquid assets, excluding inventory, which might be harder to convert into cash.Â
It is also extremely easy toÂ calculate the quick ratio. The financial data required for the ratio is usually readily available, making it a practical tool for quick financial assessments.
Creditors can use this ratio to assess a companyâ€™s ability to pay off its debts in the short term, while investors can use it to evaluate how financially sound a company is.Â
It is easy to compare theÂ quick ratio of a company with others in the same industry for a more holistic view. You can also compare it with the same companyâ€™s historical ratio values.Â
A highÂ quick ratio indicates good financial health and the ability to handle unexpected financial demands, which can boost investor confidence.
While this ratio is undoubtedly useful in many ways, it also has some downsides, as outlined below:
This ratio assumes that all the debtors will settle the companyâ€™s accounts receivables as and when they are due. However, some debtors may not pay up either completely or partially.Â
For some businesses like retail stores, inventory can be converted to cash easily. However, this aspect is ignored by theÂ quick ratio, leading to a skewed or poorer picture of the business's liquidity.Â
TheÂ quick ratio also does not account for any new or recent cash flows earned by a business. It only uses the figures available in the recent balance sheet. So, it may not offer a clear idea of the companyâ€™s current liquidity scenario.Â
Also Read:Â What is the PE Ratio? Find out the Meaning, Formula, Types and More
This is only one of the many ratios available to assess a companyâ€™s financial status before you decide whether or not to invest in it. You also need to look into other aspects like the shareholding pattern, profitability, leverage, revenue, valuation and dividend policy. If you are not sure where to find all this information at your fingertips, Motilal Oswalâ€™s Research 360 platform may be just what you need.Â
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