Introduction to Quick Ratio

When it comes to financial analysis, quick ratio calculations can help you understand a company's liquidity – and its ability to meet short-term obligations. By examining the quick ratio, investors, analysts, and stakeholders can gain valuable insights into an organization's capacity to help weather financial storms and maintain operational stability. In this article, we explore the importance of quick ratio and its practical applications when it comes to financial decision-making.

What is the quick ratio?

Quick ratio assesses a company's short-term liquidity by comparing the value of its cash balance and current assets to its near-term obligations. Also referred to as the acid test ratio or cash ratio, it determines whether a company has sufficient funds to pay its creditors in the short term if needed. The quick ratio calculation provides valuable insight into a company’s ability to meet short-term financial responsibilities or cover current liabilities – should it be required.

How is the quick ratio calculated?

Quick ratio is calculated by dividing liquid assets of a company by its current liabilities:

Quick ratio = liquid assets / current liabilities

Liquid assets are assets that can be converted to cash in a short amount of time (typically in 90 days or less in this application). This means that cash and cash equivalents, marketable securities, and accounts receivable are typically all considered liquid assets.

Current liabilities are typically defined as liabilities that will be paid off within the next 12 months. A company’s current liabilities can include a variety of account types, like accounts payable, wages payable, and current portions of long-term debt.

A quick ratio above one is considered ideal as this can indicate that a company can readily eliminate its current liabilities by utilizing its liquid assets if required. If a quick ratio is below one, then this might suggest that a company might struggle to pay off its liabilities in the short term. However, too high of a quick ratio could indicate that a business is overly liquid in the short-term because it is not putting its money to work in an efficient manner by hiring, expanding, developing, or otherwise reinvesting in its operations.

While these ratios shed light on the financial health and viability of a business, there are other considerations that come into play when determining the financial health of a company.

Current ratio vs quick ratio

Another ratio measurement tool that can be calculated is the current ratio. While both current ratio and quick ratio help assess a company's financial health, current ratio calculations bring more asset classes, into consideration.

A quick ratio offers a more conservative evaluation of the firm's liquidity position, but the current ratio calculation includes more asset and liability classes in its calculation. Assets such as inventory and pre-paid assets are included in the current ratio calculation whereas the quick ratio excludes these types of assets.

Calculations:

Quick ratio is calculated by dividing liquid assets of a company by its current liabilities:

Quick Ratio = Liquid Assets / Current Liabilities

Current ratio is calculated by dividing current assets by current liabilities:

Current Ratio = Current Assets / Current Liabilities

The current ratio divides current assets by current liabilities, whereas the quick ratio divides cash and cash equivalents by current liabilities.

A key distinction is that the quick ratio only includes current assets that can be converted into cash within 90 days or less, while the current ratio calculation includes all current assets that could be converted into cash within 12 months.

Another example of the difference between the two ratios is that current ratio will include accounts such as inventory or accounts receivable. These types of accounts aren't included in the quick ratio calculation given that they can be challenging to liquidate in a timely manner.

Finally, a quick ratio is considered more appropriate to analyze a shorter time frame of a company’s financial well-being. Whereas the current ratio will look at a longer term and incorporate more information into its calculation.

Advantages and disadvantages of using the quick ratio

Advantages:

• Considered a reliable indicator of short-term cash capabilities
• Straightforward and less complicated calculation than current ratio
• All components required to calculate are available on a company’s balance sheet
• Good for comparison with similar companies across sectors or from different time periods

Disadvantages:

• Limited to a company’s short term cash flow and does not consider future capabilities
• Potential to inaccurately report the liquidity of marketable securities during economic downturns
• Can make it appear that current liabilities have short term due dates when they generally will be longer term

How do investors use the quick ratio?

Investors typically use the quick ratio to analyze payables and receivables to measure the viability of a company.

Generally, the quick ratio will give preliminary signs of financial well-being. However, investors may want to look deeper into asset and liability details for additional cash flow indicators.

For example, a business with long-term due dates for their accounts receivable and short-term dates for their accounts payable could appear healthy based on the quick ratio but could actually be heading towards a tight cash-flow situation.

On the other hand, a business which has negotiated quick payments from customers and longer payment terms from suppliers might still have a less than desirable quick ratio yet could be financially healthy.

Hence, quick ratio in isolation might not project the true financial health of the company. With the knowledge gained from the quick ratio calculation, investors can conduct more detailed analysis of major payables and receivables in line with appropriate industries yielding more comprehensive and meaningful insights.

FAQs related to quick ratio

Why is the quick ratio important?

The quick ratio is important because it can show a company's ability to convert liquid assets into cash and fulfill short-term financial obligations. A positive quick ratio suggests that a company can weather financial emergencies if or when they are required to.

What constitutes a good quick (liquidity) ratio?

In general, a higher quick ratio reflects greater liquidity for a company. For most industries, a quick ratio above one may indicate that the business holds sufficient current assets to cover its current liabilities. Conversely, a quick ratio below 1 implies that the company might lack sufficient liquid assets to meet short-term obligations.

Is a higher quick ratio preferable?

Yes, a higher quick ratio serves as a positive indicator for a company. It indicates enhanced liquidity and the ability to generate cash promptly, especially in emergency situations. However, quick ratio alone may not be sufficient to project a company's liquidity. Hence, it's best to use it in conjunction with other financial ratios.

Conclusion

Quick ratio serves as a valuable tool for evaluating a company's short-term liquidity and financial health. By assessing a company's ability to convert liquid assets into cash to meet immediate obligations, the quick ratio provides insights into its resilience during cash flow challenges and emergencies. Quick ratios can provide valuable insight for investors, creditors, and stakeholders as they conduct comprehensive financial analysis to help them make informed decisions about a company's financial stability. On a final note, there isn’t a single ratio that can help determine a company's financial health. Hence, it's important to consider a variety of ratios in your research process.