Quick Ratio: How to Calculate It
Ratios provide one of many perspectives that build into a descriptive, financial picture. For instance, the quick ratio measures a company’s ability to use its liquid assets to pay off its short-term obligations. It provides an explanation of how the business could survive (or fail) if all its obligations came due.
This ratio is an important and common financial measure and to understand it, you need to unpack it. So, in this post, we’ll dive into the quick ratio in more detail, including a review of quick ratio examples.
What is Quick Ratio?
The quick ratio is a company’s cash, securities, and accounts receivable divided by its current liabilities. It can also be calculated as a company’s current assets minus inventory and prepaid expenses divided by its current liabilities.
In either calculation, the higher the ratio, the more liquid assets the company has available to cover its liabilities. To an investor, a company with a high proportion of liquid assets to liabilities is a safer investment.
Quick Ratio Examples
In the table below, you can see the quick ratios of two fictional companies:
|Quick Assets (QA)||$13,015||$38,167|
|Current Liabilities (CL)||$13,233||$24,394|
|Quick Ratio (QA/CL)||.98||1.56|
Company ABC has a quick ratio of .98 which means they don’t have enough liquid assets to cover their short-term debts. On the other hand, Company XYZ’s quick ratio of 1.56 indicates they can pay off their current obligations.
You can find these ratios for any public company in their quarterly report by dividing their quick assets and current liabilities.
How to Find Your Quick Ratio
To calculate your quick ratio, find your company’s balance sheet and locate the current assets and current liabilities section. Once you find the proper section, copy each variable shown below and plug them into the formula. Once you complete this step, you can calculate the result.
Quick Ratio Formula
|C = Cash and equivalents
S = Securities
AR = Accounts receivable
CL = Current liabilities
QR = Quick Ratio
|QR = (C + S + AR)/CL|
When Is This Ratio Bad for Business?
A good quick ratio is not necessarily an indicator of a healthy business. Take, for example, a company with a quick ratio of three. This means that the company has enough short-term assets that can be converted to cash flow to pay its short-term debts three times over.
However, while some liquidity is important, too much liquidity is an indication that the company is not using its assets efficiently.
An efficient company strikes a balance by spending a healthy portion of its current assets on profitable investments. For many businesses, a quick ratio of one indicates a healthy balance between liquidity and asset utilization.
What Does This Ratio Miss?
Like any single financial metric, the quick ratio doesn’t show you everything about a business. For example, if a business has a glut of late customer payments, the quick ratio might be very high. This is because accounts receivable is calculated as part of a company’s current assets, they can use to pay off short-term liabilities.
However, what the quick ratio doesn’t show is that a glut of late customer payments may cause the company to run out of cash.
Therefore, analysts don’t use quick ratios in isolation. In addition to calculating this ratio, a savvy financial analyst would also evaluate your accounts receivable aging report. That report would tell them whether the accounts receivable is truly liquid or not.
Quick Ratio vs. Current Ratio
Liquidity is a critical component of any company’s financial health. Therefore, it’s no surprise that there are additional ratios, such as the current ratio, which also measures a business’s liquidity ratio.
However, while both ratios measure liquidity, they do it in different ways. The core difference between the two ratios is that the quick ratio only uses highly liquid assets and cash in its calculation. The current, on the other hand, includes all current assets on the balance sheet.
In effect, this means the ratio is a far more conservative way to measure a company’s liquidity. The reason that it’s more conservative is that it excludes assets that may take longer to liquidate. Therefore, the quick ratio will show a lower number (indicating less liquidity) than the current ratio.
Conclusion: Put This Ratio to Use
As an entrepreneur, it’s never a bad idea to monitor your quick ratio. It can help you get a sense of how you’re balancing your liquidity and working capital needs. Plus, the ratio is a fantastic way to determine how exposed your business is to short-term financial trouble.
Beyond that, it’s also good to be familiar with the concepts behind this ratio because investors or lenders may use the term. By being aware of this concept, it shows your financial savvy if you know what they’re referring to.
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