One perspective that can describe a financial picture is the quick ratio. The quick ratio, for example, measures a company's ability to use its liquid resources to pay its short-term obligations. It explains how the company could survive (or fail) if all its obligations are paid. The quick ratio is the sum of a company's current cash, securities, assets and accounts receivables divided by its current liabilities. You can also calculate it as the company's current assets, less inventory and prepaid expenses, divided by its current liabilities.
The quick ratio is a common financial measure. In order to understand this, it's important to know how the quick ratio works. This post will discuss the quick ratio more in detail and review some quick ratio examples.
Did You Know?
If the quick ratio is more than 1, the company is in no position to tackle its immediate current liabilities, which may lead to technical solvency. Hence, you need to reduce the inventory-related investment and ensure that your ratio stays above level 1: 1.
What is the Quick Ratio?
The quick ratio measures the company's short-term capital by comparing its cash balance and current assets with its near-term obligations. The quick ratio, also known as the "acid-test ratio", is different from the current one because it uses a stricter criterion to calculate current assets. Let's understand the simplest formulas for calculating the quick ratio in this guide, as it plays an important plan in making a business plan.
Quick Ratio Formula Accounting
The quick ratio compares short-term assets to liabilities to determine if the company contains sufficient money to pay its short-term obligations.
To calculate the quick ratio, divide a company's current cash and equivalents (e.g., marketable securities) and accounts receivable are divided by the company's current liabilities.
Formula
- Quick Ratio = Cash & Equivalents + Accounts Receivable / Current Liabilities
The quick ratio is conceptually the answer to the question:
- "Does the company have sufficient cash to pay its short-term liabilities such as debt obligations due soon?"
These line items are the core components of the quick ratio:
- Current Assets: marketable securities, cash & equivalents and accounts receivables (A/R).
- Current Liabilities: accounts payable (A/P) and short-term debt.
The quick ratio is calculated by considering items part of current assets. This is because certain assets, such as inventory, are more difficult to liquidate quickly or may be difficult to sell at the same value or relative to it, i.e., in a situation where the asset is not subject to a substantial discount.
The inclusion of illiquid assets in the calculation could lead to misleading portrayals of a company's financial situation. It may mislead a company into believing it is better equipped to meet its short-term obligations.
Also Read: Definition of Liquidity Ratio and Formula With Examples
Example to Calculate Quick Ratio
Let's say, for example, that a company has:
- Marketable securities: ₹2 crore
- Cash: ₹1 crore
- Accounts payable: ₹1 crore
- Accounts receivable: ₹2 crore
The company's liquidity ratio is 5.5. This means it can pay its current obligations 5.5 times more using its most liquid assets. A ratio of 1 means that a business has sufficient cash or cash equivalents to pay its short-term financial obligations. This will allow the business to continue its operations.
Quick Ratio Formula for Excel Sheet
We will use the quick ratio formula to create the same Excel example. It's very simple and straightforward, and you need to provide the two inputs. See the template below to calculate the quick ratio formula quickly.
Quick Ratio vs Current Ratio
The quick ratio, similar to the current ratio that compares current assets and current liabilities, is also known as a liquidity rate. The quick ratio and the current ratio are calculated in a hypothetical situation where a company must pay all current liabilities that have become due by using its assets. The main difference in the quick ratio formula is that the quick ratio only includes assets that can convert into cash in 90 days or less. In contrast, the current ratio includes all assets you can convert to cash within one year. Because it deliberately ignores more liquid items such as inventory, the quick ratio can be considered more conservative than the current ratio.
How Do You Use Quick Ratio?
Once you clearly understand your company's current ratio, you can determine your total liabilities and make conservative adjustments. If your ratio analysis shows that your quick ratio exceeds your company's requirements, you may decide to use liquid assets or increase your cash flow. It might be worth considering whether or not it is feasible to turn inventory to generate cash flow.
How Do You Interpret a Quick Ratio?
The quick ratio can be used to determine your company's liquidity, and it can also help you assess your ability to pay any current liabilities with current assets. Your company's ratio is higher if it has more current assets than its current liabilities. This means that your company will likely be able to pay all of its current liabilities without selling any capital assets or long-term investments.
A quick ratio formula lower than 1 indicates that your company doesn't have enough assets to cover current liabilities in a short time. It may be necessary to sell a capital asset to pay these liabilities. A quick ratio of 1 to 2 means you have sufficient current assets to pay your current obligations.
An exact ratio of 1 indicates that your current assets are equal to your current liabilities. If your current assets are equal to your current liabilities, a ratio of 2 means that your current assets are twice your current liabilities. These results can help you understand where your company stands in relation to certain liabilities. A company's capital and long-term assets are often used to generate revenue. It is detrimental to a company's ability to generate revenue if it has to use its capital assets to pay down liabilities. Investors will also notice that the business is not earning enough to cover its liabilities.
Factors Behind Interpreting Quick Ratio Formula
Industry
The average quick ratio can differ from one industry to another. A lower ratio is fine in an industry with predictable cash flows, like retail. This is because the expected revenues can be counted upon to provide cash. On the other hand, a higher quick ratio will protect the company from revenue shortfalls in volatile or seasonal industries.
Growth
Companies that are rapidly expanding might require a higher ratio to finance investments or expand operations. Because it has relationships with lenders and suppliers, a steady business or one in decline can accept a lower ratio.
Inventory
You might have inventory that you can quickly liquidate without paying a large discount. Your current ratio (current assets/current liability) may be a better indicator for liquidity, including prepaid expenses, inventories, and other assets, whereas a quick ratio does not.
Risk
Some business owners are willing to take on some risk, even if they may face a cash crunch. A lower quick ratio may be acceptable, while a more risk-averse owner might need a higher ratio.
Economic conditions
It's a good idea to have a higher quick ratio in times of economic turmoil to deal with unexpected shocks, and the opposite is true.
All investments have inherent risks, and financial loss and asset depreciation are possible. This article contains information that is intended to be informative and referential. Before making any financial commitments, consult a professional investment advisor rather than relying on just a step guide.
Also Read: Accounting Ratios – Meaning, Types, Formulas
Investments
Investments and their strategies have inherent risks, leading to financial loss and asset depreciation. This article contains informational and referential knowledge. However, before making any financial commitments, consult a professional investment advisor. If you intend to gather more knowledge and clear your doubts, you can comment on this article, and we'll be glad to assist you.
How to Use the Quick Ratio Formula?
Once you clearly understand your company's current ratio, you can determine your total liabilities and make conservative adjustments. If your ratio analysis shows that your quick ratio exceeds your company's requirements, you may decide to use liquid assets or increase your cash flow. It might be worth considering whether or not it is feasible to turn inventory to generate cash flow.
Conclusion
It's a good idea for entrepreneurs to watch their quick ratio. This can give you an idea of your working capital and liquidity needs. The ratio can also assess how vulnerable your business is to financial troubles in the short term.
It's important to understand the concept behind the ratio as lenders and investors may also use it. This concept will reflect your financial understanding if you are aware of it.
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