The quick ratio, also known as the acid-test ratio, is a financial ratio used to measure a company’s short-term liquidity. It is calculated by subtracting inventories from current assets and then dividing the result by current liabilities.
The quick ratio is a more conservative measure of liquidity than the current ratio because it excludes inventories, which may not be easily converted into cash. A quick ratio of 1:1 or higher is generally considered a good indication that a company has enough liquid assets to cover its short-term liabilities.
However, it is important to note that the quick ratio is just one of many financial ratios used to assess a company’s financial health and should be used in conjunction with other financial metrics and qualitative factors when evaluating a company’s financial position.
It is expressed as follows:
Current liabilities include all items of all items of current liabilities except bank overdraft.
Quick Ratio Formula
In the formula, current assets refer to a company’s assets that are expected to be converted into cash within one year, while current liabilities refer to a company’s debts that are due within one year.
The formula for the quick ratio, also known as the acid-test ratio, is:
Quick ratio = (Current assets – Inventories) / Current liabilities
Quick Ratio vs. Current Ratio
The quick ratio and the current ratio are both financial ratios used to measure a company’s liquidity, but they differ in the assets included in the calculation.
The current ratio is calculated by dividing current assets by current liabilities. It measures a company’s ability to meet its short-term financial obligations using all of its current assets, including inventories.
The quick ratio, also known as the acid-test ratio, is calculated by subtracting inventories from current assets and then dividing the result by current liabilities. It provides a more conservative measure of a company’s ability to meet its short-term financial obligations because it only includes the most liquid assets.
Quick Ratio Pros and Cons
Pros:
- Conservative measure of liquidity: The quick ratio is a conservative measure of a company’s liquidity because it only considers the most liquid assets, excluding inventories which may take longer to convert to cash. Therefore, it provides a more accurate picture of a company’s ability to meet its short-term financial obligations.
- Easy to calculate: The quick ratio is a simple formula that can be easily calculated, making it a useful tool for evaluating a company’s financial health.
- Useful for credit analysis: Lenders and creditors often use the quick ratio to assess a company’s ability to repay short-term debts, making it an important factor in credit analysis.
Cons:
- Limited scope: The quick ratio only measures a company’s ability to meet its short-term financial obligations using its most liquid assets. It does not provide insight into a company’s long-term financial health or its ability to generate cash flow.
- Industry-specific: The ideal quick ratio may vary by industry. Some industries may require higher quick ratios to ensure they can cover their short-term obligations, while others may not.
- Doesn’t account for future cash inflows: The quick ratio does not take into account future cash inflows, such as anticipated sales or payments from customers. This means that it may not accurately reflect a company’s ability to meet its short-term financial obligations.
1:1 ratio is considered ideal ratio for a concern because it is wise to keep the liquid assets at least equal to the liquid liabilities at all times.
A company with a Quick Ratio of less than 1 can not currently pay back its current liabilities.
NEXT – Liquidity Measurement Ratios: Cash Ratio
Table of Contents
1) Liquidity Measurement Ratios: Introduction
2) Liquidity Measurement Ratios: Current Ratio
3) Liquidity Measurement Ratios: Quick Ratio
4) Liquidity Measurement Ratios: Cash Ratio