Quick Ratio or Acid Test Ratio – Sometimes current assets may contain huge amounts of inventory, prepaid expenses etc. This may skew the current ratio interpretations as these items are not very liquid. To address this issue, if we consider the only most liquid assets like Cash and Cash equivalents and Receivables, then it should provide us with a better picture on the coverage of short term obligations. This ratio is know as Quick Ratio or the Acid Test Ratio.
P&G’s current ratio is a 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 expense.
In this article, we look at Acid Test Ratio in detail.
- Quick Ratio Definition
- Importance of Quick ratio
- Acid Test Ratio Interpretation
- Quick Ratio Calculation
- Colgate Quick Ratio Example
- Microsoft Quick Ratio Example
Quick Ratio Definition
Quick ratio is a liquidity ratio which is used as a measure of the ability of the company to meet its current obligation. It is utilised to assess whether a business has sufficient assets that can be translated into cash to pay its bills. The key elements of current assets that are included in the quick ratio or acid test ratio are cash, marketable securities, and accounts receivable or sundry debtors excluding Inventory whereas in quick liabilities include all current liabilities excluding Bank overdraft, since it can be quite difficult to sell off in the short term, and possibly at a loss.
Since bank overdraft is secured by the inventories, the other current assets must be sufficient to meet other current liabilities. Due of the prohibition of inventory from the formula, the acid test 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 Acid test ratio or liquid ratio.
Quick ratio Formula = Quick assets / Quick Liabilities. = (Cash and Cash Equivalents + Accounts receivables) / (Current liabilities – Bank overdraft)
A quick ratio of 1: 1 indicates highly solvent position. This ratio serves as a supplement to the current ratio in analyzing liquidity.
The Importance of Quick ratio
Quick ratio is one of the major tools for the decision-making. It previews the ability of the company to make settlement its quick liabilities in a very short notice period. The major importance of the quick ratio are mentioned below:
- The acid test ratio eliminates the closing stock from the computation, which may not be necessary be always be taken as liquid, thereby giving a more suitable profile of the liquidity position of the company.
- Since closing stock is separated from current assets and bank overdraft 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, quick ratio is not impaired, as there is no requirement for valuation of the closing stock.
- Closing stock can be very seasonal and over a yearly period it may vary in quantities. If contemplate, it may collapse or escalate liquidity status. By ignoring closing stock from the computation, acid test ratio does away with this issue.
- In a sinking industry, which is generally may have very high level of closing stock; this ratio will helpful in providing more authentic repayment ability of the company as against the current ratio including closing stock.
- Because of major inventory base, short-term financial strength of a company may be overstated if current ratio is utilised. By using acid test 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 current ratio.
Quick Ratio or Acid Test Ratio Interpretation
- Quick ratio or acid test ratio is a sign of solvency 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 to continue to keep a acid test ratio that maintains adequate leverage against liquidity risk given the variables in a particular sector of business among other considerations.
- More uncertain the business environment, more it is likely that companies would keep higher quick ratios. Reversely, where cash flows are constant and foreseeable, companies would entreat to maintain quick ratio at relatively lower levels. In any case, companies must attain the correct balance between liquidity risk cause due to a low quick ratio and the risk of loss cause due to a high acid test ratio.
- A acid ratio that is higher than average of the industry may be advised that the company is investing too many resources in the working capital 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 and in case company is out of investment choices it may be advisable to return the surplus funds to shareholders in the form of hiked dividend payments.
- 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 acid test ratio due to better credit terms with suppliers than the 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.
Calculate Quick Ratio or Acid Test Ratio
Following are the illustration through which computation and analysis of acid test ratio provided.
Calculate Acid Test Ratio – Example 1
Following are the information extracted from audited records at a large size industrial company. (Amount in $)
Assume that Current Assets = Cash and Cash Equivalents + Accounts Receivables + Inventory. There are no other items included in Current Assets.
You are required to calculate the quick ratio and analyse the trend of the ratio for judging the short term liquidity and solvency of the company.
Answer to Quick Ratio Example 1.
Calculation of acid test ratio of the company for the following years.
(Amount in $)
|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 or acid test ratio = ( C ) / ( F )||1.7||1.2||0.9||0.875||0.75|
From the above calculated data, we analysed that acid test ratio has been fallen down from 1.7 in 2011 to 0.6 in 2015. This must mean that most of the current assets 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 the level 1: 1.
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 the level 1: 1.
Calculate Quick Ratio – 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 analyse the acid test ratio.
Answer to Quick Ratio 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 consider as Quick liabilities.
So, the Quick liabilities = $ 30,000
The Acid test ratio = Quick assets / Quick liabilities
= 35,000 / 30,000
As the computed acid test ratio 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 Quick Ratio Example
Let us now look at the Quick Ratio calculations in Colgate.
Acid Test 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 Quick Ratio of Colgate’s vs P&G vs Unilever
As compared to its Peers, Colgate has a very healthy quick ratio.
While, Unilever’s Quick Ratio has been declining for the past 5-6 years, we also note that P&G Quick ratio is much lower than that of Colgate.
Microsoft Quick Ratio
Let’s now look at the another example – Microsoft Quick Ratio.
As noted from the below graph, Cash Ratio of Microsoft is a low 0.110x, however, its quick ratio is a massive 2.216x.
Microsoft Quick Ratio is pretty high primarily due to to short term investments 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
- Ratio Analysis
- Financial Liabilities Ratios
- Working Capital Ratio
- PE Ratio
- Price to Book Value Ratio
As we note here that current assets may contain large amounts of inventory and prepaid expense may not be liquid. Therefore, including inventory such items will skew the current ratio from an immediate liquidity point of view. Acid Test Ratio solves this problem by not taking inventory into account. It only considers the most liquid assets including cash and cash equivalents and receivables. A quick ratio that is higher than the industry average may imply that the company is investing too much of its resources in working capital of the business which may be more profitable elsewhere. However, if the quick ratio is lower that the industry average, it suggests that the company is taking a high amount of risk and not maintaining adequate liquidity.