Quick Ratio: Definition
The quick ratio or acid test ratio is the ratio of quick assets to all current liabilities in a business.
Quick assets for this purpose include cash, marketable securities, and good debtors only. In other words, prepaid expenses and inventories are not included in quick assets because there may be doubts about the quick liquidity of inventory.
Quick Ratio: Explanation
The quick ratio is a rigorous test of a firm’s ability to pay its obligations.
It considers the fact that some accounts classified as current assets are less liquid than others. As a case in point, current assets often include slow-moving inventory items and other items which are not very liquid.
For example, inventories may take several months to sell; also, prepaid expenses only serve to offset otherwise necessary expenditures as time elapses.
These are subtracted from current assets to arrive at quick assets, which are divided by current liabilities to get the acid-test ratio. Thus, the quick ratio attempts to measure the firm’s immediate debt-paying ability.
The quick ratio is a conservative measure because it relates to the “pool” of cash and the connection between immediate cash inflows to immediate cash outflows. The old rule of thumb here was that a quick ratio of at least 1:1 would keep creditors happy.
A low ratio may indicate that the company will have trouble paying its bills.
Financial ratios are based on a given income statement and balance sheet. And in a dynamic world, we have to supplement the financial statement given at a point in time with a trend analysis of changes that have occurred over time.
Formula For Quick Ratio
To calculate the quick ratio, use the following formula:
Quick ratio (or acid test ratio) = Quick assets / Current liabilities
The data below was obtained from Fine Trading Company’s balance sheet.
- Cash: $90,000
- Marketable securities: $65,000
- Accounts receivable: $200,000
- Prepaid expenses: $15,000
- Inventory: $350,000
- Accounts payable: $95,000
- Notes payable: $10,000
- Accrued expenses: $25,000
- Short-term loan: $200,000
Required: Using this information, calculate the company’s quick ratio.
Quick ratio = Quick assets / Current liabilities
= 1.08 or 1.08 : 1
*$90,000 + $65,000 + $200,000
**$95,000 + $10,000 + $25,000 + $200,000
Fine Trading Company’s quick ratio is 1.08. This is usually comfortable for a trading company.
The quick ratio provides a more strict test of liquidity compared to the current ratio. A quick ratio of 1:1 or higher is considered satisfactory for most companies.