What is Quick Ratio? Calculation and Examples

Be it budding start-ups or established businesses offering services globally, every organization is susceptible to encountering unanticipated cash flow that forces the owners to trade assets and fund unavoidable expenditures. Inevitably, business revenue can be highly fluctuating, and occasional calamities might occur.

Hence, a business chief or potential financial investor needs to have in-depth financial literacy and realize how trading an asset can impact one’s monetary status. The concept of a quick ratio can come in handy in such situations.

What exactly is the quick ratio?

It is a method of estimating a business’s capacity to pay its short-term liabilities by having resources that can be easily converted to cash. It is also known as the “acid test ratio” and is used to gauge a company’s financial footing at any point.

Most organizations encounter irregular cash flow issues. The quick ratio aptly represents an organization’s capacity to rapidly pay for its transient monetary commitments during abrupt halts in the business. This value also aids business managers in making suitable decisions with the help of their accounting consultants.

Importance of quick ratio

More often than not, a situation may arise when an organization requires easy access to a substantial amount of cash to meet its monetary obligations. For example, there could be a natural calamity that might result in power cuts, compelling the business to halt its work and lose out on revenue, or possibly a client is late in making an enormous remittance, or a pandemic has resulted in an abrupt standstill of regular operations, leading to huge losses. In any case, salaried employees are on the payroll, and invoices do not stop pouring in.

The quick ratio then estimates an organization’s capacity to transform convertible assets into cash to pay for transient costs, climate crises, and even pandemics. The quick ratio thus addresses the degree to which a business can pay its temporary monetary commitments with its most convertible resources. As such, it estimates the extent of a business’s present liabilities that it can meet with money and its liquid assets.

Positive vs. negative quick ratio

As can be guessed easily, a positive quick ratio can hint at the company’s capacity to endure crises or different occasions that can culminate in short-term income issues. On the other hand, a negative quick ratio points towards a struggling business with lower chances of survival.

Loan specialists take into account the quick ratio since it shows the degree to which a company can pay off its monetary obligations by rapidly converting liquid assets into cash. The more liquid assets a company possesses, the better prepared it is to acclimatize to changing conditions in its business ecosystem.

A company’s quick ratio can have an optimal value of 1:1, which implies that its present resources are just enough to cover temporary obligations. Companies with low quick ratios are riskier bets for investments since their liabilities outbalance their present money reservoir.

The quick ratio estimate is thus of prime importance to lenders, banks, and investors who use it to determine if a business is worth investing in. Potential creditors try to figure out if they will get back the money invested in this trade if the business runs into financial troubles. At the same time, investors want to confirm if the business can stand tall amidst monetary distress.

Features of quick ratio

1. Quick ratio doesn’t consider the value of inventory and hence, is defined as a conservative estimate of liquidity. Along these lines, it is best utilized when assessed in concomitance with the current ratio and operating cash ratio.  

2. When divided by its current liabilities, the worth of a company’s quick assets gives an estimate of its quick ratio. Handy cash and easily-convertible resources within a brief time frame of 90 days can weigh in as quick assets. These resources are primarily marketable securities like stocks or bonds that the organization sells on regulated trades, along with some receivable accounts, which refer to cash owed to the organization by its clients under temporary credit arrangements.

3. The fundamental reason for excluding the stock, be it clothing for a retailer or vehicles for an automobile dealer, is its inability to undergo a smooth conversion into cash without significant discounts rapidly. Prepaid expenditures are also termed temporary assets, but these still cannot be easily transformed into cash, on account of which the quick ratio disregards prepaid costs.

Quick Ratio Formula and Calculations:

The quick ratio formula can be represented in the following ways:

1. As a subset of the organization’s existing assets:

 Quick Ratio = cash and cash equivalents + marketable securities + debt claim

2. As a comparison estimate between an organization’s quick assets and existing liabilities:

 Quick Ratio = quick assets / current liabilities

3. As an estimate comparing its relevance with the current assets:

 Quick Ratio = current assets – inventory – prepaid expenditures

One can thus calculate the Quick ratio with the help of the balance sheet that lists all the assets and liabilities.

The optimum value of Quick Ratio

A quick ratio equivalent to or greater than 1 implies that the organization has sufficient liquid assets for its temporary commitments. A quick ratio value of less than 1 implies that the existing liabilities weigh more than the quick assets rendering the business incapable of meeting the temporary financial obligations and creditors’ payments.

One might think that a very high quick ratio might be hinting at a well-run business. However, that is not the case since that would mean that the organization is perched on capital that could otherwise help grow the business. Availability of too much liquidity is also bad for business. It reflects that the excess liquidity is not utilized properly to churn out more business.

How does the concept of optimum quick ratio differ for distinct businesses?

The concept of an ideal quick ratio value relies on several factors pertaining to, but not limited to, the type of industry and market in which the business operates, the number of years it has been running, and its credibility. An established company with credible relationships can survive with a lower quick ratio than a newly-built start-up since the former has more possibility of auxiliary financing at low-interest rates during moments of crisis.

Quick ratio v/s Current ratio

Since the quick ratio does not include other current assets and inventory; it is more conservative than the current ratio. The main difference between the two is that the quick ratio only considers assets that can be converted to cash in a short period.

The current ratio will take into account the inventory and prepaid expense assets, which might take time to turn into cash. But, depending on the industry, a few rare organizations can turn their inventory into quick assets. Although prepaid expenses are an asset, they are omitted from the quick ratio since they cannot be used to pay for current liabilities.

Bottom line

Quick ratio is thus an indicator of an organization’s ability to pay its current financial obligations. Financial backers, suppliers, and loan specialists are more intrigued to know whether a business has a sizable amount of highly liquid assets that can be converted to cash in a short time to pay its transient liabilities. Having a clear-cut liquidity ratio is a sign of capability and sound business execution that can prompt supportable growth.