What Is the Quick Ratio?
The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets.
Since it indicates the company’s ability to instantly use its near-cash assets (assets that can be converted quickly to cash) to pay down its current liabilities, it is also called the acid test ratio. An "acid test" is a slang term for a quick test designed to produceinstant results.
- The quick ratio measures a company's capacity to pay its current liabilities without needing to sell its inventory or obtain additional financing.
- The quick ratio is considered a more conservative measure than the current ratio, which includes all current assets as coverage for current liabilities.
- The quick ratio is calculated by dividing a company's most liquid assets like cash, cash equivalents, marketable securities, and accounts receivables by total current liabilities.
- Specific current assets such as prepaids and inventory are excluded as those may not be as easily convertible to cash or may require substantial discounts to liquidate.
- The higher the ratio result, the better a company's liquidity and financial health; the lower the ratio, the more likely the company will struggle with paying debts.
What Is The Quick Ratio?
Understanding the Quick Ratio
The quick ratio measures the dollar amount ofliquid assetsavailable against the dollar amount of current liabilities of a company. Liquid assets are those current assets that can be quickly converted into cash with minimal impact on the price received in theopen market, while current liabilities are a company's debts or obligations that are due to be paid to creditors within one year.
A result of 1 is considered to be the normal quick ratio. It indicates that the company is fully equipped with exactly enough assets to be instantly liquidated to pay off its current liabilities. A company that has a quick ratio of less than 1 may not be able to fully pay off its current liabilities in the short term, while a company having a quick ratio higher than 1 can instantly get rid of its current liabilities. For instance, a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover each $1 of its current liabilities.
While such numbers-based ratios offer insight into the viability and certain aspects of a business, they may not provide a complete picture of the overall health of the business. It is important to look at other associated measures to assess the true picture of a company's financial health.
The higher the quick ratio, the better a company's liquidity and financial health, but it important to look at other related measures to assess the whole picture of a company's financial health.
Quick Ratio Formula
There's a few different ways to calculate the quick ratio. The most common approach is to add the most liquid assets and divide the total by current liabilities:
Quick assets are defined as the most liquid current assets that can easily be exchanged for cash. For most companies, quick assets are limited to just a few types of assets:
Depending on what type of current assets a company has on its balance sheet, a company may also calculate quick assets by deducting illiquid current assets from its balance sheet. For example, consider that inventory and prepaid expenses may not be easily or quickly converted to cash, a company may calculate quick assets as follows:
Regardless of which method is used to calculate quick assets, the calculation for current liabilities is the same as all current liabilities are included in the formula.
Components of the Quick Ratio
Cash is among the more straight-forward pieces of the quick ratio. A company should strive to reconcile their cash balance to monthly bank statements received from their financial institutions. This cash component may include cash from foreign countries translated to a single denomination.
Cash equivalents are often an extension of cash as this account often houses investments with very low risk and high liquidity. Cash equivalents often include but may not necessarily be limited to Treasury bills, certificates of deposits (being mindful of options/fees to break the CD), bankers' acceptances, corporate commercial paper, or other money market instruments.
In publication by the American Institute of Certified Public Accountants (AICPA), digital assets such as cryptocurrency or digital tokens may not be reported as cash or cash equivalents.
Marketable securities, are usually free from such time-bound dependencies. However, to maintain precision in the calculation, one should consider only the amount to be actually received in 90 days or less under normal terms. Early liquidation or premature withdrawal of assets like interest-bearing securities may lead to penalties or discounted book value.
Net Accounts Receivable
Whether accounts receivable is a source of quick, ready cash remains a debatable topic, and depends on the credit terms that the company extends to its customers. A company that needs advance payments or allows only 30 days to the customers for payment will be in a better liquidity position than a company that gives 90 days.
On the other hand, a company could negotiate rapid receipt of payments from its customers and secure longer terms of payment from its suppliers, which would keep liabilities on the books longer. By converting accounts receivable to cash faster, it may have a healthier quick ratio and be fully equipped to pay off its current liabilities.
The total accounts receivable balance should be reduced by the estimated amount of uncollectible receivables. As the quick ratio only wants to reflect the cash that could be on hand, the formula should not include any receivables a company does not expect to receive.
The quick ratio pulls all current liabilities from a company's balance sheet as it does not attempt to distinguish between when payments may be due. The quick ratio assumes that all current liabilities have a near-term due date. Total current liabilities are often calculated as the sum of various accounts including accounts payable, wages payable, current portions of long-term debt, and taxes payable.
Because prepaid expenses may not be refundable and inventory may be difficult to quickly convert to cash without severe product discounts, both are excluded from the asset portion of the quick ratio.
Quick Ratio vs. Current Ratio
The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are generally more difficult to turn into cash.The quick ratio considers only assets that can be converted to cash in a short period of time. The current ratio, on the other hand, considers inventory and prepaid expense assets. In most companies, inventory takes time to liquidate, although a few rare companies can turn their inventory fast enough to consider it a quick asset. Prepaid expenses, though an asset, cannot be used to pay for current liabilities, so they're omitted from the quick ratio.
Advantages and Limitations of the Quick Ratio
The quick ratio has the advantage of being a more conservative estimate of how liquid a company is. Compared to other calculations that include potentially illiquid assets, the quick ratio is often a better true indicator of short-term cash capabilities.
The quick ratio is also fairly easy and straightforward to calculate. It's relatively easy to understand, especially when comparing a company's liquidity against a target calculation such as 1.0. The quick ratio can be used to analyze a single company over a period of time or can be used to compare similar companies.
There are several downsides to the quick ratio. The financial metric does not give any indication about a company's future cash flow activity. Though a company may be sitting on $1 million today, the company may not be selling a profitable good and may struggle to maintain its cash balance in the future. There are also considerations to make regarding the true liquidity of accounts receivable as well as marketable securities in some situations.
Conservative approach on estimating a company's liquidity
Relatively straightforward to calculate
All components are reported on a company's balance sheet
Can be used to compare companies across time periods or sectors
Does not consider future cash flow capabilities of the company
Does not consider long-term liabilities (some of which may be due as early as 12 months from now)
May overstate the true collectability of accounts receivable
May overstate the true liquidity of marketable securities during economic downturns
Example of the Quick Ratio
Publicly traded companies generally report the quick ratio figure under the “Liquidity/Financial Health” heading in the “Key Ratios” section of their quarterly reports.
Below is the calculation of the quick ratio based on the figures that appear on the balance sheetsof two leading competitors operating in the personal care industrial sector, P&G and J&J, for the fiscal yearending in 2021.
|(in $millions)||Procter & Gamble||Johnson & Johnson|
|Quick Assets (A)||$15,013||$46,891|
|Current Liabilities (B)||$33,132||$45,226|
|Quick Ratio (A/B)||0.45||1.04|
With a quick ratio of over 1.0, Johnson & Johnson appears to be in a decent position to cover its current liabilities as its liquid assets are greater than the total of its short-term debt obligations. Procter & Gamble, on the other hand, may not be able to pay off its current obligations using only quick assets as its quick ratio is well below 1, at 0.45. This shows that, disregarding profitability or income, Johnson & Johnson appears to be in better short-term financial health in respects to being able to meet its short-term debt requirements.
Why Is It Called the Quick Ratio?
The quick ratio looks at only the most liquid assets that a company has available to service short-term debts and obligations. Liquid assets are those that can quickly and easily be converted into cash in order to pay those bills.
Why Is the Quick Ratio Important?
The quick ratio communicates how well a company will be able to pay its short-term debts using only the most liquid of assets. The ratio is important because it signals to internal management and external investors whether the company will run out of cash. The quick ratio also holds more value than other liquidity ratios such as the current ratio because it has the most conservative approach on reflecting how a company can raise cash.
Is a Higher Quick Ratio Better?
In general, a higher quick ratio is better. This is because the formula's numerator (the most liquid current assets) will be higher than the formula's denominator (the company's current liabilities). A higher quick ratio signals that a company can be more liquid and generate cash quickly in case of emergency.
Keep in mind that a very high quick ratio may not be better. For example, a company may be sitting on a very large cash balance. This capital could be used to generate company growth or invest in new markets. There is often a fine line between balancing short-term cash needs and spending capital for long-term potential.
How Do the Quick and Current Ratios Differ?
The quick ratio only looks at the most liquid assets on a firm's balance sheet, and so gives the most immediate picture of liquidity available if needed in a pinch, making it the most conservative measure of liquidity. The current ratio also includes less liquid assets such as inventories and other current assets such as prepaid expenses.
What Happens If the Quick Ratio Indicates a Firm Is Not Liquid?
In this case, aliquidity crisiscan arise even at healthy companies—if circumstances arise that make it difficult to meet short-term obligations such as repaying their loans and paying their employees or suppliers. One example of a far-reaching liquidity crisis from recent history is the global credit crunch of 2007-08, where many companies found themselves unable to secure short-term financing to pay their immediate obligations. If new financing cannot be found, the company may be forced to liquidate assets in a fire sale or seek bankruptcy protection.
The Bottom Line
A company can't exist without cashflow and the ability to pay its bills as they come due. By measuring its quick ratio, a company can better understand what resources they have in the very short-term in case they need to liquidate current assets. Though other liquidity ratios measure a company's ability to be solvent in the short-term, the quick ratio is among the most aggressive in deciding short-term liquidity capabilities.