What is a Quick Ratio?
The quick ratio is the short-term liquidity test of a business. It is an accounting ratio that measures the ability of a business to pay current liabilities using cash and cash equivalents.
The quick ratio considers assets that can be converted quickly into cash, hence the name quick ratio.
The conversion time for current assets into cash differs for businesses with various definitions.
Generally, assets that can be converted into cash within one year are termed current assets. Furthermore, out of these current assets that can be converted into cash within 90-120 days are termed “quick assets”.
Similarly, we use the term current liabilities for obligations of a business that are due within one year.
The quick ratio is a measure that links these current liabilities with the quick assets of a business. In other words, it measures how liquid a business is in the short term.
How to Calculate Quick Ratio?
The quick ratio determines the relationship of liquid assets with current liabilities.
The formula to calculate the quick ratio can be written in two forms:
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
We can calculate the quick ratio in a few simple steps as mentioned below.
The first step is to update the balance sheet items since all of the entries required for the quick ratio are taken from the balance sheet.
The second step is to identify all current assets and adjust for exclusions of inventory and prepaid expenses as listed in the formula above.
Alternatively, you can begin with cash and add cash equivalents like marketable securities and accounts receivable.
This will give you a quick asset figure.
Then, you’ll need to calculate the current liabilities from the balance sheet. It can be taken directly from the balance sheet summary account.
The last step is to simply divide the figure of the quick ratio with the current liabilities figure.
The result will give the quick ratio of the business for the given accounting period.
Suppose a company ABC has the following data available. We’ll calculate its quick ratio using these balance sheet items.
- Checking/Saving Account = $200,000
- Cash in Hand= $ 30,000
- Accounts Receivable = $ 300,000
- Inventory = $ 500,000
- Accounts Payable = $ 250,000
- Salaries and Wages = $ 130,000
- Taxes= $ 40,000
- Credit Card and loan Interest = $ 18,000
Total Quick Assets = Cash and Cash Equivalents + Accounts Receivable
Total Quick Assets = 200,000 + 30,000 + 300,000 = $ 530,000
Total Current Liabilities = Accounts Payable + Interest + Taxes
Total Current Liabilities = 250,000 + 130,000 + 40,000 + 18,000 = $ 438,000
Quick Ratio = Total Quick Assets/Total Current Liabilities
Quick Ratio = $530,000/$438,000 = 1.21
Interpretation of Quick Ratio
A quick ratio is a static figure it can be expressed in the ratio terms. Therefore, any figure of 1.0 or above will be considered a positive figure.
A quick ratio of above 1.0 means the company holds more quick assets than its current liabilities. It means the company can pay all its short-term liabilities using cash and cash equivalents (liquid assets) quickly if needed.
A quick ratio of 1.0 means the business is at a breakeven point in terms of its short-term liquidity. It simply means the company holds enough liquid assets to pay off its short-term obligations.
A quick ratio of less than 1.0 means the company does not hold sufficient liquid assets to pay its current obligations.
However, it is the starting point when interpreting a quick ratio.
As with any other ratio, analysts should dig deeper to find the trends across multiple accounting periods. Also, a suitable benchmark should be set to make sensible comparisons.
Understanding Component of the Quick Ratio
It is important to understand the input components of the quick ratio to improve it. We can only take measures to improve the quick ratio when we fully understand it.
Quick assets are included in the current assets. These assets can be converted into cash quickly.
Normally, if an asset is convertible into cash within 90-120 days, it is considered a quick asset. We consider only current and tangible assets under this section as they are more liquid than intangibles.
Cash and Cash Equivalents
These are the most liquid and quick assets any business can hold. Cash can be in the fiat currency or bank deposit form that can be used at any time.
Cash equivalents include a certificate of deposit, T-bills, or any other special income certificates.
These are the balances that a business needs to collect from its customers. Depending on a company’s policy, accounts receivable can be collected within 120 days.
Government bonds and stocks are the most common types of marketable securities that we can list under the quick asset section.
These securities can be quickly sold in the exchanges at a reasonable market price.
Quick assets can be differentiated from current assets with the distinction of their ability to be converted into cash quickly. Therefore, these line items should be excluded from quick assets although they are considered current assets.
Prepaid liabilities are advance payments that a business makes toward its suppliers and vendors. These are considered current assets.
However, since these assets cannot be converted into cash or realized, they should be excluded from the calculations of the quick ratio.
Inventory is another important current asset that cannot be considered a quick asset. Inventory also falls under the current asset category.
A business cannot quickly turn its inventory into finished goods and receive cash when required to settle any short-term obligation. Therefore, it should not be included in the quick asset section.
These are the obligations of a business that are payable within one year.
Loans and Interest Payments
Any portion of the long-term loans that become due in the current financial year should be included in this section. Similarly, all interest payments on all types of debt obligations should be included here.
These are the payments that a business owes to its suppliers and vendors. These obligations should include current payments and any portion of the long-term dues payable in the current period.
Estimated taxes and any other portion of the income tax that becomes due within the current financial year should be included in the current liabilities.
Any other liabilities that are payable within one year should also be included in the calculation of the quick ratio. These expenses include salaries and wages, service charges payable, prepaid products purchased by customers, and so on.
How to Improve the Quick Ratio?
Once we fully understand the components of the quick ratio, we can sort them out to improve the quick ratio.
The numerator of the quick ratio is the quick assets. It means the higher this figure the better the quick ratio.
Conversely, the denominator of the formula is the current liabilities figure. It means if this figure is lower, the quick ratio will be higher.
Improving Quick Assets
The best possible way to improve the quick ratio is to improve quick assets.
A business should maintain an adequate level of cash at any given time. The cash items include hard cash and bank deposits with the bank.
However, this cash should be deposited in the bank or used in an interest-earning instrument to boost income.
Another way of improving cash reserves is to reduce the accounts receivable cycle and increase the accounts payable cycle without affecting customer/supplier relations.
Inventory is a current asset that should be kept at an adequate level. A business should improve supplier relations to save costs and improve stock levels so that they can be converted into finished goods quickly.
Reducing Current Liabilities
Current liabilities should be managed by utilizing cash and other current assets efficiently.
The largest portion of current liabilities comes from accounts payable. It should be adjusted against the accounts receivable period to manage the working capital cycle.
Extending the payables can keep cash in hand but can affect customer relations. It can come at a cost of expensive pricing as well.
A business with improved operational efficiency and better sales would rely less on debt financing. That in turn can reduce the interest expense and current liabilities.
Managing Cash Flow
An important aspect of managing the quick ratio is to manage the cash flow of a business.
Working capital requirements are critical to keeping a steady cash flow. It can be handled by improving operational efficiency to convert raw material into finished goods quickly.
Then, a business should manage its working capital cycle to balance its cash inflow and outflow. It will also reduce its dependency on external debt financing that increases current liabilities.
Managing and improving the quick ratio is directly linked with the cash flow management of a business.
The quick ratio can be improved by either increasing quick assets or decreasing current liabilities. However, balancing both these factors requires careful attention that shouldn’t affect the long-term objectives of the business.