What is an ideal quick ratio? How is it different from the current ratio?
What is the Meaning of a Quick Ratio
The quick ratio indicates a company’s short-term liquidity position of an enterprise. It measures its ability to meet short-term obligations through its topmost liquid assets. The Quick Ratio is also termed as the Acid-test ratio or the liquidity ratio for its ability to identify the quick-cash assets that can easily pay off the short-term liabilities of a business. This implies what may be a company’s position to convert an asset into cash. These assets are generally hard cash, marketable securities, and accounts receivable or debtors. These assets are therefore known as “quick” assets as for their ability to be quickly converted into cash.
What is the Need for a Quick Ratio?
The quick ratio acts as the barometer of a company’s capabilities to pay off its short-term obligations. The interested parties to this fundamental are Investors, suppliers, lenders etc. who are more than eager to understand if a business is viable to have sufficient cash or cash equivalents to pay their money that they have invested in the business.
Also, in terms of identifying prospective investors, it shows well on a business to have a well-defined liquidity ratio. This signals competency and is an indicator of a sound business performance that may eventually lead to a sustainable growth.
As for internal business matters, a quick ratio takes into account the most liquid assets that a company can easily convert into cash to pay off their bills swiftly. Thus acting as a major contributing tool for decision-making.
Reasons for the need of a quick ratio:
- Quick ratio gives a more suitable profile to the company’s liquidity position as it eliminates the closing stock from the calculation. Evaluating the closing stock can be a sensitive issue as it may not always be at its retail value. Hence, we can conclude that the quick ratio is not impaired.
- In a sinking industry, the ratio shall help to provide the company with a significant authentic repayment ability as against the current ratio that includes the closing stock.
- By using the quick ratio, the true liquidity position can be tackled. Additionally, it shall limit the companies from getting additional loans. Now because of the high inventory base, it is likely that a company may overstate the short-term financial strength of if the current ratio is taken into order and hence deviate the interested parties.
How to Calculate the Quick Ratio?
Quick Ratio = [Cash & equivalents + marketable securities + accounts receivable] / Current liabilities
Quick Ratio = [Current Assets – Inventory – Prepaid expenses] / Current Liabilities
For example, let’s assume a company X has:
Cash: $100 Million
Marketable Securities: $200 Million
Accounts Receivable: $250 Million
Accounts Payable: $100 Million
This company shall account for a liquidity ratio of about 5.5, which means that it can pay its current liabilities 5.5 times by overusing the utmost liquid assets. A quick ratio of above 1 is an indicator that a business has sufficient amount of cash or cash equivalents to pay off its short-term financial obligations and shall be able to sustain its working operations.
Difference Between A Quick Ratio And A Current Ratio.
The quick ratio is known to be more conservative than that of the current ratio. This is because in most of the companies, inventories are supposed to take time to liquidate, which is why they are not considered while calculating a quick ratio. Also, prepaid expenses, even though they are an asset, cannot be used to pay off the current liabilities, hence they're deducted from the assets quick ratio but current ratio on the other hand, takes into account both prepaid expenses and stock, which may be viable for some companies but not all. Let us understand the core difference with the help of a table
|Current ratio||Quick ratio|
|The current ratio has a more relaxed approach while calculating a company’s debt repaying ability.||The quick ratio, however, is said to have a more stringent approach to understand a company’s debt repaying ability.|
|The current ratio calculates the proportion of current assets to its current liabilities for a company.||Quick ratio calculates the proportion of highly liquid assets i.e. quick assets to its current liabilities for a company.|
|This ratio considers all of the current assets of the company.||This ratio considers assets of a company that can be liquidated to cash in a maximum of 90 days.|
|The ideal current ratio is 2:.||An ideal quick ratio is 1:1.|
|The current ratio is interpreted to be generally higher for companies that may have a strong position in inventory.||The quick ratio is said to be ideally low for the companies with a strong position in inventory.|
As for Companies, they must focus on maintaining this ratio at an adequate leverage so as against the liquidity risk.
Well it is said that the highly uncertain the business environment, it is more likely that companies would be able to keep higher quick ratios. In contrast, companies with constant cash flows may fall on to maintain relatively lower levels of the quick ratio. Therefore it is vital that a company must strive to attain a correct balance between the liquidity risk occurring by a low ratio and the risk of loss occurring due to a high ratio.
Also, for an investor it is important to note that if the acid test ratio is higher than that of the industry’s average then the company is certain to be investing too many resources in its business working capital, which may decrease its sustained profits and thus bad news for the investors. Also, the ratio, which appears to be lower than the industry average, may be a signal that the company is at high risk by not maintaining a legitimate shield of liquid resources.
What is the formula for current ratio?
The current ratio is calculated by dividing the current assets with the current liabilities.
Why is the quick ratio preferred over the current ratio?
The quick ratio considers a more conservative approach than that of the current ratio, and does not include all the current assets as coverage for current liabilities while in calculation. Also, the higher the ratio result implies a stable position in the company's liquidity and financial health. While the current ratio may not be able to justify such a true position.
What does a quick ratio of 2 mean?
In theory, a quick ratio of 2:1 implies that a company is in a better position able to pay off its short-term obligations.