What is Quick ratio & Reasons for its Usage

The first thing you should look at while evaluating are the liquidity ratios. They are essential to analyze and measure the liquidity position of the company.

One of the significant liquidity ratios is the Quick Ratio or the Acid Test Ratio of the company.

Quick Ratio of a company indicates the ability of the company to be able to pay off the current liabilities as and when they come due with the company’s sole dependence upon its quick assets. Quick Ratio compares all the current liabilities with all the quick assets.

Quick Assets are those assets which can be converted into cash within a span of 90 days or in the short term. Quick assets may include cash and cash equivalents, marketable securities, and accounts receivable.

Formula & Example

Also, Quick Assets = Current assets – (Prepaid Expenses + Inventory)

Let us consider an example of a company XYZ ltd with the balance sheet at the year ended as follows:

Here;

• Current Assets

= Cash + Cash Equivalents + Prepaid Insurance + Inventory + Accounts Receivable

= 10,000 + 20,000 + 5,000 + 30,000 + 5,000

= 70,000

• Quick Assets

= Current assets – (Prepaid Expenses + Inventory)

= 70,000 – (5,000 + 5,000)

= 60,000

• Current liabilities

= Accounts Payable + Short-Term Debts

= 30,000 + 30,000

= 60,000

• Quick Ratio

= Liquid Assets or Quick Assets/ Current liabilities

= 60,000/60,000

=1:1

Current Ratio VS Quick Ratio

Current ratio takes into account all the current assets and do not exclude prepaid expenses and inventory/stock. Quick Ratio takes into account only those current assets which can be turned into cash in the short term so as to pay off the current liabilities of the company as and when they come due.

Naturally, prepaid expenses cannot be turned into liquid money for paying off debts as they are the expenditure of the company, which can be later realized in terms of services. Also, IInventory cannot be sold off in haste to pay current liabilities as it will hamper the company’s day to day working.

In reference to the example of company XYZ Ltd,

Current Ratio = Current Assets/ Current Liabilities = 70,000/60,000 = 1.16:1

It should be noted that a company's Current Ratio is generally greater than it's Quick Ratio (since current assets include prepaid expenses and stock as well, unlike quick assets).

Factors Affecting Quick Ratio

• Inventory Turnover: Higher inventory turnover (greater sales) will mean that the Inventory that cannot be taken into account while computing Quick Ratio may turn into cash more quickly, hence increasing and positively affecting the Quick Ratio since the company will be able to meet more liabilities with that cash.
• Collection of accounts Receivable: Shorter the period of accounts receivable, more will be the positive impact on the company's Quick Ratio. The company's chances of an encounter with bad-debts will also reduce.
• Paying Off Liabilities: Sooner the company pays off its current liabilities, lesser will be the company's denominator of Quick Ratio, hence having a positive impact on it.

Interpretation & Thumb Rule

Quick Ratio gives a clearer picture of a company's ability to handle short-term liabilities when used along with the Current Ratio.
The general Rule of Thumb for the acid test ratio is that it should be equal to 1. When the acid test ratio is 1, the value of quick assets of the company is equal to the amount of its current liabilities.

This will indicate that the company's liquidity position is good and up to the mark. A quick ratio lower than 1, indicates that the company is not fully able to pay off its current liabilities, with the help of its liquid or quick assets.

Also, a very high quick ratio, such as 4:1, is not considered very healthy for a company’s current financial position as it indicates that the company has too much idle cash which can be put to productive use.

However, the rule of thumb for this Ratio is subject to the market and internal conditions amidst which the company is operating. Hence, the ideal Quick Ratio for a company may vary according to the circumstances.

To know more about Liquidity Ratios, Click Here.