What is the Quick Ratio?
The quick ratio measures the liquidity of a business and its ability to meet its short term liabilities and debts. The ratio is calculated by dividing current assets less inventory by current liabilities. It is important to realize that the ratio is similar to the current ratio. However, for this ratio, inventory is excluded from current assets as inventory can sometimes be difficult to convert into cash. Additionally, the ratio is also known as the Acid Test Ratio or Liquidity Ratio.
Quick Ratio Formula
To calculate the ratio use the quick ratio formula shown below.
In the quick ratio formula the terms have the following meanings.
- Firstly, current assets are given in the balance sheet and includes cash, accounts receivable, and inventory. Generally prepaid expenses are excluded from the calculation.
- Secondly, current liabilities are also found in the balance sheet and includes accounts payable and short term (due in less than 1 year) debt. There is discussion as to whether overdrafts should be included in the current ratio calculation. Strictly speaking overdrafts are payable on demand and are therefore part of current liabilities. However, in practice under normal circumstances, a bank will view the business relationship as an ongoing one and overdrafts could be excluded. In the balance sheet format used below overdrafts have been left out of the calculation.
- Finally, inventory is again shown on the balance sheet of the business.
How to Calculate Quick Ratio in Practice
Ratio Calculation Example 1:
| Cash | 5,000 |
| Accounts receivable | 125,000 |
| Inventory | 20,000 |
| Current assets | 150,000 |
| Long term assets | 390,000 |
| Total assets | 540,000 |
| Accounts payable | 90,000 |
| Other liabilities | 10,000 |
| Current liabilities | 100,000 |
| Long-term debt | 210,000 |
| Total liabilities | 310,000 |
| Capital | 60,000 |
| Retained earnings | 170,000 |
| Total equity | 230,000 |
| Total liabilities and equity | 540,000 |
In the above example the current assets are 150,000, inventory is 20,000 and the current liabilities are 100,000. Consequently the calculation of the quick asset ratio is as follows:
Quick ratio = (Current Assets - Inventory) / Current Liabilities Quick ratio = (150,000 - 20,000) / 100,000 = 1.30
Ratio Calculation Example 2:
| Cash | |
| Accounts receivable | 110,000 |
| Inventory | 20,000 |
| Current assets | 130,000 |
| Long term assets | 220,000 |
| Total assets | 350,000 |
| Accounts payable | 120,000 |
| Other liabilities | 40,000 |
| Current liabilities | 160,000 |
| Long-term debt | 180,000 |
| Total liabilities | 340,000 |
| Capital | 5,000 |
| Retained earnings | 5,000 |
| Total equity | 10,000 |
| Total liabilities and equity | 350,000 |
In Example 2 above the current assets are 130,000, inventory is 20,000 and the current liabilities are 160,000. Consequently the calculation of the quick asset ratio is as follows:
Quick ratio = (Current Assets - Inventory) / Current Liabilities Quick ratio = (130,000 - 20,000) / 160,000 = 0.69
Quick Ratio Interpretation
It is generally considered that current assets are readily convertible to cash. However, inventory can sometimes be difficult to convert and so is excluded from current assets when calculating the ratio. What the quick asset ratio shows is the ability of the business to generate enough cash to repay its current liabilities should they all be demanded at once when the business does not have the ability or time to sell its inventory.
Firstly in example 1 above the ratio is 1.30 which means that for every 1 the business owes it can quickly generate 1.30 in cash to make payment.
Secondly in example 2 above the ratio is 0.69 and the business is only able to generate cash of 0.69 for every 1 it owes. Clearly in the unlikely event of all current liabilities being demanded at the same time the business would be unable to make payment.
An increasing quick ratio over time indicates that the business is either tying up more and more money in account receivables, which might indicate a lack of efficiency in debt collection, or it is paying its suppliers and reducing accounts payable too quickly.
Conversely a quick ratio which is reducing overtime shows that accounts receivable are reducing or that further credit is being taken from suppliers.This may indicate the onset of liquidity problems for the business in the near future.
Useful tips for Using the Acid Test Ratio
- The quick ratio will vary from industry to industry. To make comparisons you need to use a comparable business operating in your sector.
- A quick ratio in the region of 1:1 is normally considered acceptable. The higher the ratio the more liquidity the business has. However a ratio which is too high implies a lot of money tied up in debtors or as cash sitting in the bank. It is generally accepted that money tied up in this way earns very little or nothing for the business.
- Some businesses, particularly low margin supermarkets, operate with negative working capital which means that current assets less inventory is less than current liabilities and the quick ratio is less than 1. Providing the level of risk (in not being able to repay all liabilities on demand) is acceptable then it shows that the business is able to fund its investment in debtors using credit from its suppliers thereby reducing its borrowings.
- A bank manager may include overdraft facilities in the calculations, and will want to see a high quick asset ratio as it shows a lower risk business.