Understanding Quick Ratio: Meaning, Formula, Significance, Limitations and More

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 company’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 company’s financial health. 

So, how do you measure the liquidity of a company? One way is to use the quick ratio. In this article, we discuss the meaning of the quick ratio, how it works, the quick ratio formula and how to calculate the quick ratio, among other things. 

What is the Quick Ratio?

The 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. 

If a company’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 company’s books of accounts and acts as a positive sign for investors. 

Since the 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 the quick ratio along with other key financial ratios to assess its financial strength and position. 

Understanding the Quick Ratio

Investors often simply look into a company’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 — which is rarely a good sign over the long term. 

The 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. 

Quick Ratio Formula

Now that you have seen the meaning of the quick ratio and how it works, let us discuss how to calculate the quick ratio. From its definition, you know that this ratio compares the quick assets of a company with its current liabilities. So, the quick ratio formula is:

Quick ratio = Quick assets ÷ Current liabilities 

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 securities 

Or

Quick assets = Total current assets — Inventory — Prepaid expenses 

Once you find the value of the quick assets, you can plug it into the quick ratio formula and use it to calculate the quick ratio. 

Key Components of the Quick Ratio

At first glance, it is evident from the meaning of the quick ratio that it consists of two components — namely, quick assets and current liabilities. However, what do each of these components include? Let’s find out.

• Quick Assets: 

Quick assets form a part of a company’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. 

Some of the most common examples of quick assets include the following:

• Cash: This includes the cash balance in a company’s accounts. It may also take into account any cash available in foreign currency. However, the denomination should be made uniform before using the cash balance to calculate the quick ratio. 
• Cash Equivalents: Cash equivalents include low-risk liquid investments that can easily be sold for cash. Some examples of such quick assets include Commercial Papers (CPs), Treasury Bills, Certificates of Deposit (CDs) etc. 
• Net Accounts Receivables: Accounts receivables are the payments that are owed to a company by its customers. Different accounts receivables may have different payment cycles. You must only consider those accounts that can be collected within 90 days. 
• Marketable Securities: These are highly liquid securities that can be sold in the market for cash quickly. For finding the quick ratio, only those securities that can be redeemed within 90 days are considered. 

• Current Liabilities: 

Unlike current assets, which are not entirely considered in the quick ratio, all the current liabilities of a company are taken into account. This number can be found in a company’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. 

An Example of How to Calculate the Quick Ratio

Having seen the 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. 

Say there are two companies with the following financial parameters. The table below shows you how their quick ratios vary.

Interpreting the Quick Ratio

Once you find the 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 company’s liquidity is. So, in our example, company 1 has lower liquidity than company 2. 

Here are some general thumb rules you can use to understand what different values of the quick ratio mean.

• Quick ratio < 1: This means that the company does not have enough liquid or quick assets to cover its current liabilities. So, it may have to rely on external financing to repay the dues. 
• Quick ratio = 1: This means that the company’s liquid assets are equal to its current liabilities in value. This can be a precarious position because if the quick assets reduce even slightly (or if the current liabilities increase), the ratio becomes unfavourable.
• Quick ratio > 1: This means that the company has more quick assets than current liabilities. So, it can comfortably pay off its short-term liabilities with just the cash and cash-convertible assets it currently owns. 

Significance of the Quick Ratio

The quick ratio is important for investors due to various reasons. Its top advantages include the following:

• Liquidity Assessment

The quick ratio gives a clear picture of a company’s short-term liquidity by focusing on its most liquid assets, excluding inventory, which might be harder to convert into cash. 

• Easy Calculation

It is also extremely easy to calculate the quick ratio. The financial data required for the ratio is usually readily available, making it a practical tool for quick financial assessments.

• Useful for Creditors and Investors

Creditors can use this ratio to assess a company’s ability to pay off its debts in the short term, while investors can use it to evaluate how financially sound a company is. 

• Facilitates Comparative Analysis

It is easy to compare the quick ratio of a company with others in the same industry for a more holistic view. You can also compare it with the same company’s historical ratio values. 

• Financial Health Indicator

A high quick ratio indicates good financial health and the ability to handle unexpected financial demands, which can boost investor confidence.

Limitations of the Quick Ratio

While this ratio is undoubtedly useful in many ways, it also has some downsides, as outlined below:

• Assumptions About Debtors’ Credibility 

This ratio assumes that all the debtors will settle the company’s accounts receivables as and when they are due. However, some debtors may not pay up either completely or partially. 

• Exclusion of Inventory

For some businesses like retail stores, inventory can be converted to cash easily. However, this aspect is ignored by the quick ratio, leading to a skewed or poorer picture of the business's liquidity. 

• Recent Cash Flows Ignored

The 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 company’s current liquidity scenario. 

Also Read: What is the PE Ratio? Find out the Meaning, Formula, Types and More

Conclusion

This is only one of the many ratios available to assess a company’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 Oswal’s Research 360 platform may be just what you need. 

With a wide range of fundamental stock screeners that cover all the important factors from shareholding to dividend ratios, this platform can help you make sound investments for the long term.