Quick Ratio Formula: How to Calculate & Examples

Tally Quick ratio formula
|Updated on: July 21, 2022

What is the quick ratio?

Quick ratio is also known as the acid test ratio and it provides insight into how prepared a business is to convert its liquid assets in case of an emergency or immediate expenses. Sometimes, an emergency can cause a dent in a business savings and a quick ratio enables you to understand whether your business will suffer as a result or if you can weather the storm with your available liquid assets. Quick ratio shows you how well you are covered for the time you have sudden cash flow issues in the short-term. Quick ratio is often used along with operating cash ratio and current ratio rather than in isolation.

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Why is quick ratio important?

Quick ratio can be used by anyone but it is of high importance to investors and lenders. Investors want to know that the business they are investing in has the ability to meet sudden emergencies when they arise. This is why they use the quick ratio to ensure the company can be trusted. Lenders are more willing to give loans to those companies which are capable of returning their money on time. They use the quick ratio to determine and decide whether they should provide loans to the business or if it is a risky prospect to do so.

That said, it is important to know that the quick ratio doesn’t throw light on how your business will meet dues when the cash flow is normal. It should only be used to know two things. One, the ability of your business to emerge from an emergency situation whereby you had to spend a significant amount of your cash. Second, a quick ratio shows whether a temporary problem with cash flow will stop your business from operating normally or if you will be able to come out of the problem without any issues.

Is the quick ratio the same as the current ratio?

Quick ratio and current ratio may sound familiar but they are different. Quick ratio and current ratio have only one thing in common; they are used to compare assets compared to the current liabilities of a company. Quick ratio factors in just the high liquid assets like cash while the current ratio factors in all the current assets of a company. That is, the current ratio includes inventory which is not a highly liquid asset. This is why the quick ratio and current ratio are different metrics that are used in different circumstances and to get insights into different aspects of the business.

Quick ratio formula

The quick ratio formula is as follows.

Quick ratio = Quick assets / Current liabilities

Where,

Quick assets = Cash and cash equivalents + Marketable securities + Accounts receivables

Another formula for quick assets is as follows.

Quick assets = Current assets – Inventory – Prepaid expenses

Components of quick ratio formula

The various components of the quick ratio formula are as follows.

Quick assets are those current assets which can be converted to cash quickly. Quick assets include the accounts receivable, cash and cash equivalents, and marketable securities. Quick assets do not include inventory and prepaid expenses as these cannot be converted as quickly as the other mentioned previously.

Current liabilities are those which are due to be paid within an operating cycle or within a year. The operating cycle or cash conversion cycle refers to the time taken by businesses to convert inventory to goods that they can sell. Examples of current liabilities include accounts payable, dividends payable, current maturities of long-term debt, and short-term debt.

How to calculate a quick ratio?

You can calculate the quick ratio by getting the values from the balance sheet. First, you want the value of the quick assets. You can do this by finding the values of cash and cash equivalents along with accounts receivable. You will also need to factor in the marketable securities. Some businesses will have trade receivables or trade debtors, and this is the value you want to include for the quick assets. Second, you want to look for the current liabilities value. You will find the specific values in the balance sheet. Then just add the quick assets and divide the number by the current liabilities value. The result is the quick ratio.

Example of quick ratio

Example 1

A company has a balance sheet as follows.

Current assets

 

Accounts receivable

$200,000

Marketable securities

$15,000

Cash and cash equivalents

$30,000

Total current assets

$245,000

Current liabilities

 

Accounts payable

$150,000

Accrued expenses

$20,000

Other short-term liabilities

$5,000

Total current liabilities

$175,000

The quick assets in this case are going to be the addition of the accounts receivable, marketable securities, and cash and cash equivalents which is $245,000. Now using the quick ratio formula, the calculation will be $245,000 divided by $175,000 = 1.4. This company has a quick ratio of 1.4.

In this example, the quick assets calculation was simple because all the assets were quick assets. What if that is not the case? Let us explore the case in the second example.

Example 2

Another company has a balance sheet that is like this.

Current assets

 

Accounts receivable

$100,000

Marketable securities

$50,000

Cash and cash equivalents

$20,000

Inventory

$300,000

Prepaid expenses

$10,000

Total current assets

$480,000

Current liabilities

 

Accounts payable

$120,000

Accrued expenses

$60,000

Other short-term liabilities

$10,000

Total current liabilities

$190,000

The current assets for this company are not all quick assets. Inventory and prepaid expenses are not a part of quick assets and so we need to calculate the total quick assets without them. This would be $100,000 + $50,000 + $20,000 which is equal to $170,000.

The quick ratio will be calculated by dividing the quick assets by current liabilities. It would be $170,000 divided by $190,000 which equals to 0.89.

Quick ratio analysis

Let us examine the examples above and determine which of the two companies is in a better position.

In the first scenario, the company had a quick ratio that was more than 1 while in the next example the quick ratio was less than 1.

Businesses with a quick ratio that is more than 1 have sufficient liquid assets to meet their financial obligations in the case of an emergency or when they experience temporary financial problems. But businesses with a quick ratio of less than 1 show that they don’t have enough quick assets at present to meet their financial obligations if something goes wrong. This makes it difficult for them to pay back to lenders and it also increases the interest that they have to pay which further worsens their situation.

Does this mean that it is best to always have a quick ratio of more than 1? It depends on the exact quick ratio value. While a quick ratio of more than 1 is desirable, a quick ratio that is way too high isn’t that good for a business either. That is because it can mean that you have capital that you may not be using to its full potential. Perhaps, you can use the capital to invest or expand your business. Does this mean there is no optimal quick ratio? No really. Although it is better to have a quick ratio more than 1, trying to keep it close to 1 is the best option.

The industry in which the business operates also dictates the optimal quick ratio as it can vary. For instance, if a company has been in business for years, then it means it has a solid relationship with its suppliers. If it has a good credit history along with this then this type of business can do with a lower than 1 quick ratio without any problems. The reason is that the business can sustain itself even if it has low quick assets because it can easily negotiate due to strong relationships with suppliers and so on.

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