Quick Ratio Definition
Quick ratio, also known as the acid test ratio measure the ability of the company to repay the short term debts with the help of the most liquid assets and it is calculated by adding total cash and equivalents, accounts receivable and the marketable investments of the company and then dividing it by its total current liabilities.
Due to the prohibition of inventory from the formula, this ratio is a better sign than the current ratio of the ability of a company to pay its instant obligations. It is also known as the Acid test ratio or liquid ratio.
Quick ratio Formula = Quick assets / Quick Liabilities. = (Cash and Cash EquivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more + Accounts receivables) / (Current liabilities – Bank overdraft)
A ratio of 1: 1 indicates a highly solvent position. This ratio serves as a supplement to the current ratio in analyzing liquidity.
P&G’s current ratio is healthy at 1.098x in 2016; however, its quick ratio is 0.576x. This implies that a significant amount of P&G current asset is stuck in lesser liquid assets like Inventory or prepaid expenses.
The Importance of Quick ratio
This ratio is one of the major tools for decision-making. It previews the ability of the company to make settlement its quick liabilities in a very short notice period.
- This ratio eliminates the closing stock from the calculation, which may not be necessary be always be taken as a liquid, thereby giving a more suitable profile of the liquidity position of the company.
- Since closing stock is separated from current assets and bank overdraftsBank OverdraftsOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer.read more and cash credit are eliminated from current liabilities as they are usually secured by closing stock, thereby preparing the ratio more worthy in ensuring the liquidity position of the company.
- Evaluation of closing stock can be sensitive, and it may not always be at saleable value. Therefore, the quick ratio is not impaired, as there is no requirement for the valuation of the closing stock.
- Closing stock can be very seasonalClosing Stock Can Be Very SeasonalClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level.read more, and over a yearly period, it may vary in quantities. I contemplate, it may collapse or escalate liquidity status. By ignoring closing stock from the calculation, the ratio does away with this issue.
- In a sinking industry, which is generally may have a very high level of closing stock, this ratio will help in providing more authentic repayment ability of the company against the current ratio, including closing stock.
- Because of the major inventory base, the short-term financial strength of a company may be overstated if the current ratio is utilized. By using this ratio, this situation can be tackled and will limit companies getting an additional loan, the servicing of which may not be as simple as reflected by the current ratio.
Interpretation Quick Ratio
- It is a sign of solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more of an organization and should be analyzed over a time period and also in the circumstances of the industry the company controls in.
- Basically, companies should focus on continuing to keep this ratio that maintains adequate leverage against liquidity riskLiquidity RiskLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.read more, given the variables in a particular sector of business, among other considerations.
- More uncertain the business environment, the more it is likely that companies would keep higher quick ratios. Reversely, where cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more are constant and foreseeable, companies would entreat to maintain the quick ratio at relatively lower levels. In any case, companies must attain the correct balance between liquidity risk caused due to a low ratio and the risk of loss caused due to a high ratio.
- An acid ratio that is higher than the average of the industry may be advised that the company is investing too many resources in the working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)"read more of the business, which may more profitably be used elsewhere.
- If a company has extra supplementary cash, it may consider investing the excess funds in new ventures. In case the company is out of investment choices, it may be advisable to return the surplus funds to shareholders in the form of hiked dividend payments.
- The Acid Test Ratio, which is lower than the industry average, may suggest that the company is taking a high amount of risk by not maintaining a proper shield of liquid resources. Otherwise, a company may have a lower ratio due to better credit termsCredit TermsCredit Terms are the payment terms and conditions established by the lending party in exchange for the credit benefit. Examples include credit extended by suppliers to buyers of products with terms such as 3/15, net 60, which essentially implies that although the amount is due in 60 days, the customer can avail a 3% discount if they pay within 15 days.read more with suppliers than its competitors.
- When interpreting and analyzing the acid ratio over various periods, it is necessary to take into account seasonal changes in some industries which may produce the ratio to be traditionally higher or lower at certain times of the year as seasonal businesses experience illegitimate effusion of activities leading to changing levels current assets and liabilities over the time.
Analysis of Quick Ratio
The following are the illustration through which calculation and interpretation of the quick ratio provided.
Example 1
The following are the information extracted from audited records at a large size industrial company. (Amount in $)
| Particulars | 2011 | 2012 | 2013 | 2014 | 2015 |
|---|---|---|---|---|---|
| Current assets | 1,10,000 | 90,000 | 80,000 | 75,000 | 65,000 |
| Inventory | 8,000 | 12,000 | 8,000 | 5,000 | 5,000 |
| Current Liabilities | 66,000 | 70,000 | 82,000 | 1,00,000 | 1,00,000 |
| Bank overdraft | 6,000 | 5,000 | 2,000 | 0 | 0 |
Assume that Current Assets = Cash and Cash Equivalents + Accounts ReceivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more + Inventory. There are no other items included in Current Assets.
You are required to calculate the quick ratio and analyze the trend of the ratio for judging the short term liquidity and solvency of the company.
Answer to Example 1.
Calculation of the quick ratio of the company for the following years:
(Amount in $)
| Particulars | 2011 | 2012 | 2013 | 2014 | 2015 |
|---|---|---|---|---|---|
| Current assets ( A ) | 1,10,000 | 90,000 | 80,000 | 75,000 | 65,000 |
| Less: Inventory (B) | 8,000 | 12,000 | 8,000 | 5,000 | 5,000 |
| Quick Assets (C) = (A – B ) | 1,02,000 | 78,000 | 72,000 | 70,000 | 60,000 |
| Current Liabilities ( D ) | 66,000 | 70,000 | 82,000 | 80,000 | 80,000 |
| Less: Bank overdraft ( E ) | 6,000 | 5,000 | 2,000 | 0 | 0 |
| Quick Liabilities (F) = (D – E) | 60,000 | 65,000 | 80,000 | 80,000 | 80,000 |
| Quick Ratio = ( C ) / ( F ) | 1.7 | 1.2 | 0.9 | 0.875 | 0.75 |
From the above-calculated data, we analyzed that the quick ratio has been fallen down from 1.7 in 2011 to 0.6 in 2015. This must mean that most of the current assetsThe Current AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more are locked up in stocks over a period of time. The ideal standard quick ratio is 1: 1. It means that the company is not in a position to meet its immediate current liabilities; it may lead to technical solvency. Hence, steps should be taken to reduce the investment in the inventory and see that the ratio is above level 1: 1.
The ideal standard ratio is 1: 1. It means that the company is not in a position to meet its immediate current liabilities; it may lead to technical solvency. Hence, steps should be taken to reduce the investment in the inventory and see that the ratio is above level 1: 1.
Example 2
XYZ Limited provides you the following information for the year ending 31st March 2015.
- Working Capital = $45,000
- Current ratio = 2.5 Inventory = $40,000
You are required to calculate and interpret a quick ratio.
Answer to Example 2
- Calculation of Current assets and Current liabilities
Given working capital is $ 45,000
Current ratio = 2.5
= Current assets / Current liabilities = 2.5 = Current assets = 2.5 * Current Liabilities
So, working capital = Current Assets – Current Liabilities
= 45,000 = 2.5 Current Liabilities – current liabilities
= 1.5 * current liabilities = 45,000
= current liabilities = 45,000 / 1.5 = 30,000
Therefore, current assets = 2.5 * current liabilities = 2.5 * 30,000 = 75,000
So, current assets and current liabilities are $ 75,000 and $ 30,000 respectively.
- Calculation of acid test ratio
Given Inventory = $40,000
Current assets = $75,000
So, the Quick assets = Current assets – Inventory = $ 75,000 – $ 40,000 = $ 35,000
As there is no bank overdraft available Current liabilities will be considered as Quick liabilities.
So, the Quick liabilities = $ 30,000
Therefore,
Ratio = Quick assets / Quick liabilities
= 35,000 / 30,000
= 1.167
As the calculated acid test ratioCalculated Acid Test RatioAcid test ratio is a measure of short term liquidity of the firm and is calculated by dividing the summation of the most liquid assets like cash, cash equivalents, marketable securities or short-term investments, and current accounts receivables by the total current liabilities. The ratio is also known as a Quick Ratio.read more is 1.167, which is more than the ideal ratio 1, it reflects that the company is better able to meet its obligation through quick assets.
Colgate Example
Let us now look at the calculations in Colgate.
The ratio of Colgate is relatively healthy (between 0.56x – 0.73x). This acid test shows us the company’s ability to pay off short term liabilities using Receivables and Cash & Cash Equivalents.
Below is a quick comparison of the Ratio of Colgate’s vs. P&G vs. Unilever
source: ycharts
As compared to its Peers, Colgate has a very healthy ratio.
While Unilever’s Quick Ratio has been declining for the past 5-6 years, we also note that the P&G ratio is much lower than that of Colgate.
Microsoft Example
As noted from the below graph, the Cash RatioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.read more of Microsoft is a low 0.110x. However, its quick ratio is a massive 2.216x.
source: ycharts
Microsoft Quick Ratio is pretty high, primarily due to short term investmentsShort Term InvestmentsShort term investments are those financial instruments which can be easily converted into cash in the next three to twelve months and are classified as current assets on the balance sheet. Most companies opt for such investments and park excess cash due to liquidity and solvency reasons.read more of around $106.73 billion! This puts Microsoft in a very comfortable position from the point of view of liquidity / Solvency.
source: Microsoft SEC Filings
Quick Ratio Video
Conclusion
As we note here that current assets may contain large amounts of inventory, and prepaid expensesPrepaid ExpensesPrepaid expenses are expenses for which the company paid in advance in an accounting period but which were not used in the same accounting period and have yet to be recorded in the company's books of accounts.read more may not be liquid. Therefore, including inventory, such items will skew the current ratio from an immediate liquidity point of view. Quick Ratio solves this problem by not taking inventory into account. It only considers the most liquid assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet.read more, including cash and cash equivalents and receivables. A ratio that is higher than the industry average may imply that the company is investing too much of its resources in the working capital of the business, which may be more profitable elsewhere. However, if the quick ratio is lower than the industry average, it suggests that the company is taking a high amount of risk and not maintaining adequate liquidity.
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