Quick Ratio

Do the company’s current assets easily cover its current liabilities?

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What is the Quick Ratio?

The Quick Ratio, also known as the Acid-test or Liquidity ratio, measures the ability of a business to pay its short-term liabilities by having assets that are readily convertible into cash. These assets are, namely, cash, marketable securities, and accounts receivable. These assets are known as “quick” assets since they can quickly be converted into cash.

The Quick Ratio Formula

Quick Ratio = [Cash & equivalents + marketable securities + accounts receivable] / Current liabilities

Or, alternatively,

Quick Ratio = [Current Assets – Inventory – Prepaid expenses] / Current Liabilities

Example

For example, let’s assume a company has:

• Cash: \$10 Million
• Marketable Securities: \$20 Million
• Accounts Receivable: \$25 Million
• Accounts Payable: \$10 Million

This company has a liquidity ratio of 5.5, which means that it can pay its current liabilities 5.5 times over using its most liquid assets. A ratio above 1 indicates that a business has enough cash or cash equivalents to cover its short-term financial obligations and sustain its operations.

The formula in cell C9 is as follows = (C4+C5+C6) / C7

This formula takes cash, plus securities, plus AR, and then divides that total by AP (the only liability in this example).

The result is 5.5.

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What’s Included and Excluded?

Generally speaking, the ratio includes all current assets, except:

• Prepaid expenses – because they can not be used to pay other liabilities
• Inventory – because it may take too long to convert inventory to cash to cover pressing liabilities

As you can see, the ratio is clearly designed to assess companies where short-term liquidity is an important factor. Hence, it is commonly referred to as the Acid Test.

The Quick Ratio In Practice

The quick ratio is the barometer of a company’s capability and inability to pay its current obligations.  Investors, suppliers, and lenders are more interested to know if a business has more than enough cash to pay its short-term liabilities rather than when it does not. Having a well-defined liquidity ratio is a signal of competence and sound business performance that can lead to sustainable growth.

To learn more about this ratio and other important metrics, check out CFI’s course on performing financial analysis.

Quick Ratio vs Current Ratio

The quick ratio is different from the current ratio, as inventory and prepaid expense accounts are not considered in quick ratio because, generally speaking, inventories take longer to convert into cash and prepaid expense funds cannot be used to pay current liabilities. For some companies, however, inventories are considered quick assets; it depends entirely on the nature of the business, but such cases are extremely rare.