Last Updated on 1 year by Antony C.
‘Quick Ratio’ refers to the liquidity ratio that assesses the ability of a company to cover its short-term liabilities. This is done by calculating all assets that can be easily converted into cash. The name itself ‘Quick Ratio’ comes from the idea that only those assets that can be quickly liquidated are used to calculate.
Another name for the ‘Quick Ratio’ is the ‘Acid Test Ratio’.
Numbers considered as Quick assets are:
- Cash
- Marketable securities
- Accounts receivables
- Other Current Asset
‘Quick Ratio’ is a relatively more conservative approach to the current ratio as it only uses assets that are cash or cash equivalent to assess the ability to repay short-term liabilities.
Quick Ratio Formula
Quick Ratio can be calculated by dividing the sum of cash, marketable securities, accounts receivables, and other current assets by the total current liabilities.
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable + Other Current Assets) / Total Current Liabilities
The other way of calculating the Quick Ratio is by subtracting inventories and prepaid expenses from total current assets followed by dividing by the total current liabilities.
Quick Ratio = (Total Current Assets – Inventories – Prepaid Expenses) / Total Current Liabilities
How To Interpret Quick Ratio?
Calculated Quick Ratio of a company is Equal to 1
When the calculated quick ratio is 1, it means the liquid assets are equal to its current assets. This also means that the company is able to pay off its current debts without selling its long-term assets.
Calculated Quick Ratio of a company is Greater Than 1
When the calculated quick ratio is greater than 1, it means the company has more than enough liquid assets to be used to repay the current liabilities. This is a good quick ratio and the most desirable quick ratio of a company.
Calculated Quick Ratio of a company is Smaller Than 1
When the calculated quick ratio is less than 1, it means that the company does not have enough liquid assets to be used to repay the current liabilities. This is a bad quick ratio for a company.
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Example of Quick Ratio Analysis
Let’s use an example to understand the calculation of the Quick Ratio formula better.
John is a smart investor who is thinking of investing at ABC Company.
John knows that if he does a proper fundamental analysis of the company, he can understand more about the financial health of the company. Thus he will be able to make a better-informed decision before he put his money into the company.
Quick Ratio is just one of the many fundamental analysis numbers that John needs to calculate. This number allows him to have a rough gadget of the financial health of the company he is going to invest in.
The company has provided the following information on the website:
| Description | Amount |
|---|---|
| Cash | $1,000 |
| Marketable Securities | $0 |
| Net Account Receivable | $2,000 |
| Total Current Liabilities | $1,500 |
What is a quick ratio with the example?
Out of the above-mentioned current assets; only cash, marketable securities, and net receivable can be considered to be quick assets.
The quick ratio is calculated as follows
Quick Ratio = (Cash + Marketable Securities + Net Accounts Receivable) / Total Current Liabilities
Quick Ratio = ($1,000 + $2,000) / $1,500
Quick Ratio = 2.0
The calculated quick ratio of the company is 2.0. The calculated Quick Ratio is more than 1.0 which is a comfortable liquidity position.
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Advantages And Disadvantages Of Quick Ratio
There are many pros and cons to using a quick ratio to assess the quality of a stock. Like any other fundamental analyst metric, the quick ratio should be used with other similar metrics to give a better overview of the quality of the stock.
Advantages of Quick Ratio
- A quick Ratio is a conservative liquidity ratio. The ratio calculated only uses assets that can be quickly converted to cash to assess the ability to repay current liabilities.
- Inventories are not used as it takes too long to convert inventories into cash. This helps investors and management to have a clearer idea about the liquidity position of the company.
- The quick Ratio is one of the easiest ratios to understand. Thus people who do not have a deep understanding of accounting and finance tend to use this ratio for assessment.
- Illustrated as a ratio, Quick Ratio can be used to compare companies.
Tip: Use Quick Ratio to compare companies that have similar sizes and industries.
Disadvantages of Quick Ratio
- Quick Ratio doesn’t provide any information about the company’s cash flow. The cash flow of a company is always one of the most important factors in the assessment of the liquidity of a company.
- Some assumptions such as accounts receivable might not be as such readily available for collection. This is especially true during a market downturn.
- During a market downturn, marketable securities may find it difficult to trade in the market.
Why Is Quick Ratio Important To Investors?
The quick ratio measures a company’s capacity to pay its current liabilities without needing to sell its inventory or obtain additional financing.
Quick Ratio is a great tool to measure the liquidity of a company. Quick Ratio is a liquidity ratio analysis that is a more conservative approach than the Current Ratio but less conservative than the Cash Ratio.
This liquidity ratio is commonly used in fundamental analysis to help investors assess the liquidity position of a company.
Learning these fundamental analyses is an important step for you to become a smart investor.
“Taking your first step is always hardest. But it is the most important step to greatness”
A.C.
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Antony C.
Founder & Financial Writer at Income Buddies | Website | Posts by Author
Antony C. is a dividend investor with over 15+ years of investing experience. He’s also the book author of “Start Small, Dream Big“, certified PMP® holder and founder of IncomeBuddies.com (IB). At IB, he share his personal journey and expertise on growing passive income through dividend investing and building online business. Antony has been featured in global news outlet including Yahoo Finance, Nasdaq and Non Fiction Author Association (NFAA).
