MEANING AND FORMULA
It is also known as liquid ratio or acid test ratio
it is a measure of a company's short-term liquidity. The Formula for calculating quick ratio is
Quick Assets / Current Liabilities
Quick Assets = Current Assets - Inventory - Prepaid Expenses
For meaning of current assets and current liabilities please refer to this article
It is a pure ratio and is a key metric for regular monitoring
EXPLANATION
To explain it in layman terms - What part of my assets are such that these can be converted into cash or cash equivalents fast to pay off short term liabilities. The quick ratio is a way to measure how much money a company has available to pay its bills right now. To calculate the quick ratio, we take the company's cash, which is money it has on hand like in a bank account, and add up the money it's expecting to receive from customers who have bought things on credit (this is called accounts receivable) and any other short-term investments the company has made. Then, we divide that total by the amount of money the company owes to other people and businesses in the short-term (these are called current liabilities).
EXAMPLE
Let's say Company X has the following financial information:
- Cash: Rs50,000
- Accounts Receivable: Rs20,000
- Short-term Investments: Rs10,000
- Current Liabilities: Rs40,000
To calculate the quick ratio, we would add up the cash, accounts receivable, and short-term investments, which comes to Rs50,000 + Rs20,000 + Rs10,000 = Rs80,000. Then, we would divide that total by the current liabilities, which comes to Rs80,000 / Rs40,000 = 2.
This means that Company X has a quick ratio of 2, which is considered healthy because it's equal to or greater than 1. This indicates that the company has enough liquid assets to cover its short-term liabilities.
INTERPRETATION
The quick ratio is a more stringent measure of liquidity than the current ratio, which includes inventory in the numerator. This is because inventory is considered the least liquid of a company's assets and may not be easily converted to cash in the short term.
The quick ratio is used to evaluate a company's ability to meet its short-term obligations using its most liquid assets. A ratio of 1 or higher is generally considered healthy, indicating that a company has sufficient liquid assets to cover its short-term liabilities. A ratio lower than 1 may indicate that a company may have difficulty paying its short-term debts.
Other Points to Note (For Advanced Users)
It is pertinent to note that lower quick ratio does not always mean poor financial health
- The quick ratio can be affected by a company's industry and business model. For example, companies that have a lot of inventory on hand or that operate in industries with long payment cycles (such as construction or manufacturing) may have lower quick ratios than companies that operate in industries with shorter payment cycles (such as consulting or software development).
- It's important to compare a company's quick ratio to industry benchmarks or to the quick ratios of its competitors to get a sense of how it compares. This can help provide context for the company's financial performance and identify potential areas of concern.
- The quick ratio can be affected by a company's use of debt. Companies that have high levels of debt may have lower quick ratios because they have more current liabilities, which can make it more difficult to meet their short-term obligations.
- The quick ratio should be considered in the context of a company's overall financial health and performance. For example, a company with a high quick ratio but declining revenues or profitability may still be at risk of financial difficulties.
- It's important to remember that the quick ratio is just one tool among many that can be used to evaluate a company's financial health. Other financial ratios, such as the current ratio, the debt-to-equity ratio, and the return on equity, can also provide valuable insights into a company's financial performance.