What is Quick Ratio in Finance and How to Calculate It?

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What is a Quick Ratio?

Cash is an indispensable resource for business firms as cash works as a fuel to run business operations successfully. Lack of cash may push a company to insolvency which is an inability to pay the current expenses. Long-term insolvency may push firms to bankruptcy. Therefore, knowing the position of a company in terms of available cash or liquidity is of utmost importance for the firm. Here’s where the quick ratio comes in handy.

A quick ratio is an indicator of a firm’s ability to meet short-term expenses. In simple, it can be termed as the indicator of a company’s ability to pay the short-term expenses that occur within a specified period of time, such as one year. Also called ‘Acid Test Ratio’, the Quick Ratio measures the firm’s ability to pay the short-term liabilities arising from time to time.

How to Calculate Quick Ratio?

Quick Ratio is generally calculated using the following formula −

$$\mathrm{Quick \:Ratio\:=\:\frac{Quick\: Assets}{Current\: Liabilities}}$$

Quick Assets

Quick assets are the current assets that can be readily converted into cash within a short span of time. This includes cash equivalents and cash, marketable securities, such as publicly-traded bonds and shares and commercial papers, and accounts receivable. It does not include inventories and prepaid expenses as these cannot be converted into cash quickly.

Current Liabilities

Current liabilities include all items that must be paid within a period of one year. This includes the common accounts payable items, such as taxes, interest, wages, bills, insurance, and utilities. This also includes the applicable long-term debt that must be paid within one year.

How to Calculate Quick Ratio Using Other Formulas?

Quick Ratio can be calculated using two other formulas which are the following −

Formula 1

This formula considers items that can be converted to cash easily and very quickly. Inventories are not considered because although they may be converted to cash it may take more time than the usual limit. To get inventories converted into cash, they may be sold off but a huge discount must be applied.

$$\mathrm{Quick\: Ratio\:=\:\frac{Current \:Assets\:-\:Inventories\:-\:Prepaid\: expenses}{Current\: Liabilities}}$$

Prepaid expenses include items like insurance and prepaid subscriptions. They are omitted because they cannot be used to pay off current liabilities. In theory, they may be canceled and refunded but it will take a long time and there is a chance of not receiving the full amount.

Formula 2

This second formula is similar to the above but it considers the items that can be readily converted to cash.

$$\mathrm{QR\:=\:\frac{Cash\:+\:Cash\: Equivalents\:+\:Marketable\: Securities\:+\:Accounts\: Receivable}{Current \:Liabilities}}$$

Accounts receivable, however, may sometimes have an issue as they can be non-exact, non-paid, or take a longer time than a year. However, they can often be collected within a year unless there is historical evidence of the opposite.

Conclusion

From the owner’s point of view, putting more of the net profits into cash accounts may increase the value of the quick ratio which may be more impressive to the investors. Business owners can also invest more profit into a cash equivalent and marketable securities to magnify the quick ratio. Moreover, the liabilities can be reduced by repaying debt and reducing expenses.

Alternately, when the Quick Ratio is too large, some of the assets may be adjusted to net profits to make the figure impressive. Higher quick ratios are impressive because it shows a firm’s ability to meet the short and long-term needs efficiently. It shows that the firm will be capable of paying the interests and long-term dues on time. This may lead to a favor from the lenders because lenders prefer borrowers who may meet the payment obligations effectively. The quick ratio, therefore, must be respectable and impressive so that the company stays competitive in the market.

raja
Updated on 15-Apr-2022 13:10:40

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