Quick Ratio

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 Equivalents + 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.

Quick-Ratio-v1

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 overdrafts 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 seasonal, 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

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 $)

Particulars20112012201320142015
Current assets1,10,00090,00080,00075,00065,000
Inventory8,00012,0008,0005,0005,000
Current Liabilities66,00070,00082,0001,00,0001,00,000
Bank overdraft6,0005,0002,00000

Assume that Current Assets = Cash and Cash Equivalents + Accounts ReceivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.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 $)

Particulars20112012201320142015
Current assets ( A )1,10,00090,00080,00075,00065,000
Less: Inventory (B)8,00012,0008,0005,0005,000
Quick Assets (C) = (A – B )1,02,00078,00072,00070,00060,000
Current Liabilities ( D )66,00070,00082,00080,00080,000
Less: Bank overdraft ( E )6,0005,0002,00000
Quick Liabilities (F) = (D – E)60,00065,00080,00080,00080,000
Quick Ratio = ( C ) / ( F )1.71.20.90.8750.75

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 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 Example

Let us now look at the calculations in Colgate.

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

Quick-Ratio-Colgate-vs-PG-vs-Unilver

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.

Microsoft-Quick-Ratio-v1

source: ycharts

Microsoft Quick Ratio is pretty high, primarily due 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.

microsoft-short-term-investments

source: Microsoft SEC Filings

Quick Ratio Video

Conclusion

As we note here that current assets may contain large amounts of inventory, and prepaid expenses 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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