Quick Ratio

Do the company’s assets easily cover its liabilities?

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. The basis for this are assets that are readily convertible to cash and equivalents. These assets are, namely, cash, marketable securitiesand accounts receivable. These assets are known as quick assets, since they can quickly be liquidated.

To differentiate from current ratio, inventory and prepaid expense accounts are not considered in quick ratio because generally inventories take longer to convert into cash and prepaid cannot be used to pay current liabilities. For some companies, however, inventories are considered a quick asset, although that depends entirely on the nature of the business and these cases are extremely rare.

The Formula

Quick Ratio =

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

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 2.2, which means that it can repay its current liabilities 2.2 times over using its most liquid assets. A rate above 1 strongly suggests that a business has enough cash or cash equivalents to pay expenses or loans and sustain its operations.

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 is not.  Having a well defined liquidity ratio is a signal of competence and sound business performance that can lead to sustainable growth.

The quick ratio is an important metric when performing financial analysis.