What is Quick Ratio
Quick ratio is a tool to measure a company’s ability to pay off short-term liabilities with high-liquidity assets. The quick ratio is a comparison between the current assets without relying on inventory and prepaid expenses with current liabilities.
High-liquidity assets include:
- Cash
- Short-term investment (marketable securities)
- Account receivable
Therefore, the quick ratio is a comparison between cash, short-term investment, and receivable with current liabilities. It is the more liquidity version of the current ratio.
The reason that the quick ratio excluded inventory from the equation is that you need to sell these inventory first, in case you need to pay off your obligations. Inventories are typically the least liquid of a business’s current assets. So, if sales become slow, they might not be converted to cash as quick as the business need.
For the prepaid expense, as you can guess, you can’t use the prepaid expense to pay your debt at all.
Key Points
- Quick ratio is a comparation between high liquidity asset with the current liabilities, use for measures a company’s ability to pay off short-term liabilities.
- The higher the quick ratios, the less liquidity risk a business has.
- However, sometime extreamly high levels of liquidity can prevent the business against liquidity crisis, but also show bad management and cause lower income than its should be.
Quick Ratio Meaning
The quick ratio is a financial ratio that reflects the ability to pay off short-term obligations (debt) with high-liquidity assets. The quick ratio shows how many times the company had high-liquidity assets than its short-term debt.
A higher quick ratio indicates a strong liquidity of the company. Likewise, a lower quick ratio indicates a worst liquidity of the company. Normally, compare the value with the industry average, competitor company, or your company’s history.
The higher the quick ratios, the less liquidity risk a business has. However, extremely high levels of liquidity can prevent the business against liquidity crisis, but also show bad management and cause lower return on assets.
Calculate the Quick Ratio
The quick ratio is calculated by dividing the cash, short-term investments, and receivables by current liabilities. The calculation of quick ratio can be computed as following formula:
Quick Ratio = (Cash + Short term investment + Receivables) ÷ Current Liabilities
For example, the Feriors company’s balance sheet shows the following statement:
- Cash – 3 million
- Short-term investment – 2 million
- Account receivable – 1 million
- Current liabilities – 2 million
Solution:
Quick ratio = (3 million + 2 million + 1 million) ÷ 2 million = 3 times
The Feriors’s quick ratio is 3 times which means the company’s high-liquidity assets (cash, short term investment, and account receivables) are 3 times more than current liabilities.
