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

Example

The data below was obtained from Fine Trading Company’s balance sheet.

Current assets:

  • Cash: $90,000
  • Marketable securities: $65,000
  • Accounts receivable: $200,000
  • Prepaid expenses: $15,000
  • Inventory: $350,000

Current liabilities:

Required: Using this information, calculate the company’s quick ratio.

Solution

Quick ratio = Quick assets / Current liabilities
= *$355,000/$330,000**
= 1.08 or 1.08 : 1
*$90,000 + $65,000 + $200,000
**$95,000 + $10,000 + $25,000 + $200,000

Interpretation

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.

Quick Ratio or Acid Test Ratio Calculator

Frequently Asked Questions

What is the quick ratio rule of thumb?

The quick ratio or acid test ratio is a firm's ability to pay its liabilities. It is calculated by dividing current assets that can be converted into cash in one year, by all current liabilities.

When should you use the quick ratio?

When analyzing Financial Statements, it is very important to use the correct Financial Ratios. You should always use the most recent income statement and balance sheet. However, you will want to use the quick ratio when analyzing a firm's liquidity position in order to gain an idea of how quickly they could pay off their short-term debts. If they can't, then there may be some problems in terms of liquidity.

How is the quick ratio calculated?

To calculate the quick ratio, compare current assets that can be converted into cash within one year to all current liabilities. The quick ratio is used as a test of liquidity because it does not include inventories or prepaid expenses (if any). A rule of thumb for good liquidity is to have a quick ratio of at least 1:1.

How is the current ratio different from the quick ratio?

The quick ratio provides a stricter test of liquidity compared to the current ratio. The quick asset includes cash and short-term investments such as marketable securities, Accounts Receivable, prepaid expenses and inventory (if any). Current assets include cash, Accounts Receivable, inventories and short-term investments.

What is the difference between a quick ratio and a current ratio?

The quick ratio or acid test ratio is a measure of liquidity that measures a company's ability to pay off its existing liabilities. The current ratio, which simply divides total current assets by total current liabilities, is often used as a proxy for the quick ratio. While usually accurate, this approximation does not always represent the total liquidity of the firm.

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