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
Quick Ratio = [Current Assets – Inventory – Prepaid expenses] / 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 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 a quick asset – it depends entirely on the nature of the business, but such cases are extremely rare.
Thank you for reading this guide to understanding the Acid Test as a measure of a company’s liquidity. CFI is the official provider of the FMVA Certification for financial modeling analysts. This program focuses heavily on Excel, accounting, and financial modeling skills.
To keep learning and advancing your career as a financial analyst, these additional CFI resources will help you on your way: