Even well-run businesses may experience unforeseen cash flow issues that require them to sell assets to cover expenses — after all, revenue is rarely static month to month, and disasters happen. But how do you as a business leader or potential investor know how selling an asset, like securities or accounts receivable, will affect your financial standing?
The quick ratio is one way to measure a business’s ability to quickly convert short-term assets into cash. Also known as the “acid test ratio,” the quick ratio is an indicator of a company’s liquidity and financial health.
What Is Quick Ratio?
What if a company needs quick access to more cash than it has on hand to meet financial obligations? Perhaps a hurricane knocked out power for several days, forcing the business to close its doors and lose sales, or maybe a customer is late making a large payment — but payroll still needs to be run, and invoices continue to flow in.
Most businesses experience sporadic cash flow problems. The quick ratio measures a company’s ability to convert liquid assets into cash to pay for short-term expenses and weather emergencies like these.
- The quick ratio measures a company’s ability to quickly convert liquid assets into cash to pay for its short-term financial obligations.
- A positive quick ratio can indicate the company’s ability to survive emergencies or other events that create temporary cash flow problems.
- Lenders and investors use the quick ratio to help decide whether a business is a good bet for a loan or investment.
- The quick ratio is considered a conservative measure of liquidity because it excludes the value of inventory. Thus it’s best used in conjunction with other metrics, such as the current ratio and operating cash ratio.
Quick Ratio Explained
The quick ratio represents the extent to which a business can pay its short-term obligations with its most liquid assets. In other words, it measures the proportion of a business’s current liabilities that it can meet with cash and assets that can be readily converted to cash.
The quick ratio is also known as the acid test ratio, a reference to the fact that it’s used to measure the financial strength of a business. A business with a negative quick ratio is considered more likely to struggle in a crisis, whereas one with a positive quick ratio is more likely to survive.
Quick Ratio Formula
The quick ratio formula is:
Quick ratio = quick assets / current liabilities
Quick assets are a subset of the company’s current assets. You can calculate their value this way:
Quick assets = cash & cash equivalents + marketable securities + accounts receivable
If it’s not possible to identify all of these individual asset types on the balance sheet, the total value of quick assets can be deduced from the value of current assets using this formula:
Quick assets = current assets – inventory – prepaid expenses
You can find the value of current liabilities on the company’s balance sheet.
What Is Included in the Quick Ratio?
The quick ratio is the value of a business’s “quick” assets divided by its current liabilities. Quick assets include cash and assets that can be converted to cash in a short time, which usually means within 90 days. These assets include marketable securities, such as stocks or bonds that the company can sell on regulated exchanges. They also include accounts receivable — money owed to the company by its customers under short-term credit agreements.
Why isn’t inventory included?
Stock, whether clothing for a retailer or automobiles for a car dealer, is not included in the quick ratio because it may not be easy or fast to convert your inventory into cash quickly without significant discounts. The quick ratio also doesn’t include prepaid expenses, which, though short-term assets, can’t be readily converted into cash.
Quick Ratio vs Current Ratio
The quick ratio is one way to measure business liquidity. Another common method is the current ratio. Whereas the quick ratio only includes a company’s most highly liquid assets, like cash, the current ratio factors in all of a company’s current assets — including those that may not be as easy to convert into cash, such as inventory. Both ratios compare assets against the business’s current liabilities.
Current liabilities are defined as all expenses a business is due to pay within one year. The category can include short-term debts, accounts payable and accrued expenses, which are debits that the company has recognized on the balance sheet but hasn’t yet paid.
Quick Ratio Analysis
The quick ratio measures a company’s ability to raise cash quickly when needed. For investors and lenders, it’s a useful indicator of a company’s resilience. For business managers, it’s one of a suite of liquidity measures they can use to guide business decisions, often with help from their accounting partner.
Other important liquidity measures include the current ratio and the cash ratio.
The quick ratio is a stricter measure of liquidity than the current ratio because it includes only cash and assets the company can quickly turn into cash. However, the quick ratio is not as strict a measure as the cash ratio, which measures the ratio of cash and cash equivalents to current liabilities. Unlike the quick ratio, the cash ratio excludes accounts receivable.
The quick ratio also doesn’t say anything about the company’s ability to meet obligations from normal cash flows. It measures only the company’s ability to survive a short-term interruption to normal cash flows or a sudden large cash drain.
How to Calculate Quick Ratio
Financial managers can calculate their company’s quick ratio by identifying the relevant assets and liabilities in the company’s accounting system. Investors and lenders can calculate a company’s quick ratio from its balance sheet. Here’s how:
- From the balance sheet, find cash and cash equivalents, marketable securities and accounts receivable, which you’ll sometimes see listed as “trade debtors” or “trade receivables.” These are the quick assets.
- On the balance sheet, find “current liabilities.”
- Add up the quick assets. Then divide them by current liabilities.
The result is the quick ratio.
Quick Ratio Examples
This company’s current assets consist entirely of quick assets, so calculating the quick ratio is straightforward:
Quick ratio = quick assets / current
Company B’s total current assets include inventory and prepaid expenses, which are not part of the quick ratio. However, the quick assets are separately identified, so we can calculate the quick ratio using the extended formula:
Quick ratio =
(cash & cash equivalents + marketable securities + accounts receivable) / current liabilities
= (15,000 + 5,000 + 5,000)/37,500
So which company is in a better position to receive funding to cover its short-term obligations?
Why Is Quick Ratio Important?
The quick ratio is widely used by lenders and investors to gauge whether a company is a good bet for financing or investment. Potential creditors want to know whether they will get their money back if a business runs into problems, and investors want to ensure a firm can weather financial storms.
The quick ratio is an important measure of the company’s ability to meet its short-term obligations if cash flow becomes an issue.
What Is a Good Quick Ratio?
A quick ratio that is equal to or greater than 1 means the company has enough liquid assets to meet its short-term obligations.
However, an extremely high quick ratio isn’t necessarily a good sign, since it may indicate the company is sitting on a significant amount of capital that could be better invested to expand the business.
The optimal quick ratio for a business depends on a number of factors, including the nature of the industry, the markets in which it operates, its age and its creditworthiness. For example, an established business with strong supplier relationships and a good credit history may be able to operate with a significantly lower quick ratio than a startup because it’s more likely to obtain additional financing at low interest rates and/or negotiate credit extensions with suppliers in the event of an emergency.
What Does a Quick Ratio Under 1 Mean?
If a business’s quick ratio is less than 1, it means it doesn’t have enough quick assets to meet all its short-term obligations. If it suffers an interruption, it may find it difficult to raise the cash to pay its creditors.
In addition, the business could have to pay high interest rates if it needs to borrow money.
How Do Client Payments Affect a Business’s Quick Ratio?
The quick ratio includes payments owed by clients under credit agreements (accounts receivable). But it doesn’t tell us when client payments are due, which can make the quick ratio misleading as a measure of business risk.
For example, suppose Company A has current liabilities of $15,000 and quick assets comprising $1,000 cash and $19,000 of accounts receivable, with customer payment terms of 90 days. Its quick ratio is 1.33, which looks rather good.
But suppose it has a supplier payment of $5,000 falling due in 10 days. Unless a large number of its customers pay what they owe within 10 days, the company won’t have enough cash available to meet its obligation to the supplier — despite its apparently good quick ratio. It may have to look at other ways to handle the situation, such as tapping a credit line for the funds to pay the supplier or paying late and incurring a late fee.
Now consider Company B, which has current liabilities of $15,000 and quick assets comprising $10,000 cash and $4,000 of accounts receivable, with customer payment terms of 30 days. Its quick ratio is 0.93, so it looks a lot weaker than Company A.
Company B, too, has a $5,000 supplier payment falling due in 10 days. But unlike the first company, it has enough cash to meet that supplier payment comfortably — despite its lower quick ratio.
All told, client payments and supplier terms both affect a company’s ability to meet its short-term obligations. However, the quick ratio doesn’t factor in these payment terms, so it may overstate or understate a company’s real liquidity position. In addition, the quick ratio doesn’t take into account a company’s credit facilities, which can significantly affect its liquidity.
Advantages and Disadvantages of the Quick Ratio
There are a number of advantages to using the quick ratio:
- During hard times, a business’s ability to leverage its cash and other short-term assets can be key to survival. Too often, businesses facing cash flow problems have to sell inventory at a heavy discount or borrow at very high interest rates to meet immediate obligations.
- The quick ratio is a useful indicator of a company’s ability to manage cash flow problems without resorting to fire sales or borrowing money.
However, the quick ratio has several significant disadvantages.
- The quick ratio ignores supplier and customer credit terms. This can give a misleading impression of asset liquidity.
- The quick ratio doesn’t tell you anything about operating cash flows, which companies generally use to pay their bills.
- For companies that can sell inventory fast, the quick ratio can be a misleading representation of liquidity. For these companies, the current ratio — which includes inventory — may be a better measure of liquidity.
Limitations of Quick Ratio
The main limitation of the quick ratio is that it assumes a company will meet its obligations using its quick assets. But generally speaking, companies aim to meet their obligations from operating cash flow, not by using their assets. The quick ratio doesn’t reflect a company’s ability to meet obligations from its operating cash flows; it only measures the company’s ability to survive a cash crunch.
Another limitation of the quick ratio is that it doesn’t consider other factors that affect a company’s liquidity, such as payment terms and existing credit facilities. As a result, the quick ratio does not provide a complete picture of liquidity. Experts recommend using it in conjunction with other metrics, such as the cash ratio and the current ratio.
How Your Company Can Use the Quick Ratio
In business, cash flow is king and the accounts receivable gap is real. The ability to rapidly convert assets to cash can be pivotal to help the company survive a crisis. The quick ratio provides insight into your company’s ability to sell assets if needed.
Maintaining an optimal quick ratio may also help you get favorable interest rates if you need a loan, and it can make your company more attractive to investors.
If your company’s quick ratio is below the average for your industry and market, you can improve it in a number of ways. For example, you could increase quick assets by cutting operating expenses, or you could reduce current liabilities by refinancing short-term loans with longer-term debt or negotiating better prices with suppliers.
If your company’s quick ratio is significantly above average, it suggests that you might be able to make better use of your cash by using it to fund business expansion, perhaps by increasing investments in plants or machinery, hiring more staff or acquiring another company.
To figure out the best way forward, companies often consult with managerial accountants who have experience analyzing business costs and operational metrics and using that insight to assist executives in the decision-making process.
While the quick ratio yields insights into a company’s ability to pay its short-term financial obligations and is often used by creditors and investors to help decide whether a business is a good bet for a loan or investment, it’s not a perfect indicator. We recommend using it in conjunction with other business metrics.
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