A lack of cash might not send alarm bells ringing right off the bat.
But…it does pose a substantial threat to the company’s financial position.
Cash is essential for business expenditure and liability payments. Hence, a lack of it can push a company into bankruptcy.
So, the main question for investors is how to get an accurate estimation of the cash reserves of a company?
The clear-cut answer happens to be the Quick Ratio.
The Quick Ratio is the most appropriate methodology to analyse a company’s liquidity position, and it will inform how a company might perform when things start rolling south.
How?
Well. For the know-how, one needs to understand the quick ratio definition. So, without any further ado, let us dive in.
The Quick Ratio, otherwise called the Acid Test Ratio or Liquid Ratio, is an efficient measure to identify the financial health of a business.
It tells an investor whether a company can pay its liabilities without risking its assets. A quick ratio suggests how easy it is for the firm to convert its assets into cash so that the company can have a cushion during difficult times of crisis.
But what does quick ratio mean exactly?
A quick ratio is a proportion established by deducting inventories and prepaid expenses from current assets and dividing the resulting amount by the current liabilities.
The calculation of Quick Ratio (QR) has two folds.
The first formula is calculated by adding up the Marketable Securities (MS), Cash and Equivalents (CE), and Account Receivables (AR) and dividing them by Current Liabilities (CL).
The formula is:
Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivables)/ Current Liabilities.
The second formula is calculated by deducting prepaid expenses and inventories from the current assets and dividing the result by current liabilities.
The formula is:
Quick Ratio = Current assets – (Inventories + Prepaid Expenses)/ Current Liabilities.
The quick assets include assets that are easy to liquidate within 90 days or less.
Quick assets are already liquid or can be liquidated approximately within 90 days or less.
These assets include cash and cash equivalents like savings accounts, deposit certificates, and treasury bills that are supposed to mature within 90 days. It also includes marketable securities like bonds and stocks along with accounts receivables.
It is a sum of cash and cash equivalents, marketable securities, and account receivables.
The components of Quick assets are as follows:
Current liabilities are the obligations that the company should pay within a year. Like wages, taxes, interest on loans and other instruments, utilities, insurance premiums, and account payables.
If a part of long-term debt is to be paid within a year, that portion is included in current liabilities.
The components of current liabilities are as follows:
The ratio includes almost all current assets, for the most part, except
This exclusion of specific elements indicates that the quick ratio is designed to analyse the companies in terms of short-term liquidity as an essential factor. Hence, it is also commonly referred to as the Acid Test Ratio, given its all-buttoned-up approach.
Let us explain the Quick Ratio with the help of a hypothetical example. Let us assume a textile wholesaler company named Meraki Fabrics has the following data:
Bills payable = 40,000
Sundry Creditors = 3,00,000
Sundry Debtors = 1,40,000
Cash in Hand = 30,000
Cash at Bank = 2,20,000
Bank loan = 2,00,000
Stock in Trade = 2,70,000
Then, how do you calculate its Quick Ratio?
We know that
Quick Ratio = Quick Assets/Current Liabilities.
Now,
The calculation of quick assets includes summing Cash in Hand and at Bank and Sundry Debtors. The calculation for the following are:
2,50,000 + 1,40,000 = 3,90,000
Similarly, the calculation for current liabilities includes summing Sundry Creditors and Bills Payable. The calculation for the following are:
3,00,000 + 40,000 = 3,40,000
So, the Quick Ratio would be = 3,90,000/3,40,000 = 1.14.
This ratio indicates that company Meraki Fabrics can pay its dues 1.14 times its actual value.
The ideal Quick Ratio is 1:1, and this result of 1:1 suggests that the company has enough assets to pay its short-term obligations. The current assets used in the quick ratio are the ones that can liquidate within a day or two.
A company with a quick ratio value below one might fall short of paying its short-term debts fully. But, a quick ratio above one signifies a company that can immediately pay its short-term debt.
Similar to the Current Ratio, the quick ratio offers a synopsis of short-term financial health but fails to represent the whole picture of a company.
It is vital to consider other financial ratios to have a full-fledged assessment of the financial position of an organisation.
So, how do investors analyse a company with the help of a quick ratio? Is it beneficial or not?
Well, the final judgement depends on various factors, and they are as follows:
Quick ratios vary by industry, and a low quick ratio is appropriate for companies with sectors that have regular cash flow. A predictable cash flow assures a future supply of cash when required, and this predictability is constant in industries like retail.
However, for volatile or seasonal industries, a high quick ratio is mandatory to ascertain the stability of a company.
Some proprietors like to take risks, leading them to face a cash crunch. So, for such owners, a low quick ratio is acceptable.
But, business owners that look for risk-free operations might want a high quick ratio.
A company that is still growing and has not reached its peak yet might require a higher quick ratio to expand its operation and gain the trust of the investors and creditors.
However, a company with already established loyal relationships with its creditors and suppliers can work with a lower quick ratio.
A high quick ratio is essential during an economic crisis to survive unforeseen circumstances.
However, during phases of stability in the economy, a low quick ratio is acceptable.
If a company possesses inventory that can quickly liquidate, then the quick ratio is not a fair indicator of that company’s financial position.
Instead, one should look at the current ratio of such companies to get a more holistic picture.
If the account receivable of a company is circulated regularly and steadily, then the company can work with a low quick ratio.
However, a company that needs to wait for a substantial period before receiving payment from its customers needs to have a higher quick ratio to prevent cash shortfalls.
A very high quick ratio indicates that the company is not using its money correctly, and it shows the inefficiency of a company using its cash for expansion and growth.
A company with predictable customer payments can work with a low quick ratio, but it should be at par with the ratio average of other companies in the same industry.
Business owners use a sly trick to increase their quick ratio by distributing the net profits into marketable securities and cash and cash equivalents. Similarly, if the percentage is higher, a company can use the extra cash for growth and expansion.
From a creditors’ point of view, a higher quick ratio is better. A higher quick ratio ensures the creditor or supplier that the company is a suitable debtor, which improves the company’s creditworthiness.
Other ratios that can be used to analyse a company are – Current Ratio and Cash Ratio.
An organisation can experience a lump sum of customer payments during a specific period, which may spike the quick ratio.
But, if the payment gets delayed or they are rolled out at an extended credit period such as 150 days depending on the sale, the company might not be able to meet its current liabilities in time.
Business expenses and creditors require instant payment, and not having sufficient funds can lead to failed payments which may hamper the business’s reputation. Hence, even after having a healthy quick ratio, a company cannot clear its short-term liabilities given its accounts receivables.
However, if a company can ensure quick payments from its customers and negotiate more extended credit periods with its creditors and suppliers, it would lead to the fast conversion of cash and slow the rate of outstanding liabilities. This practice will encourage a healthy quick ratio in the company, thereby boosting its ability to pay off its current liabilities. Can we rely on customer payments for quick and ready cash? This is a controversial question because the reliance is based on the company’s credit policy that it has extended to its customers.
If a company accepts only advance payment or provides a 30 days credit period, it will have a healthier quick ratio than a company that allows 90 days credit period.
Now, the credit policy of creditors and suppliers also affects a company’s liquidity position.
Hence, If a company has a 60-day credit period for its customers but receives a 150 days credit period from its suppliers, it will have a robust Quick Ratio as long as the customer payments are equal to or more than the accounts payable.
A few elements of the quick assets like cash and cash equivalents and marketable securities like stocks and bonds are free from credit period dependencies. Hence, they rarely affect the quick ratio.
But, withdrawal of the assets before their maturity or liquidating them before the designated time can lead to penalties that can reduce the expected value.
To better understand the liquidity position, one should only consider the customer payments that are due within 90 days or less to avoid payment failures of suppliers.
The ultimate difference between the Current Ratio and the Quick Ratio is the difference in measuring a firm’s liquidity.
The Quick Ratio appears to be strict with its methodology. It does not include inventory and other assets that cannot turn into cash instantly, and the Quick Ratio is tough in terms of liquidity measurement of an organisation.
Both Current Ratio and Quick Ratio include receivables during their measurement. However, not all receivables are quickly liquidated. So, they both might misrepresent to a certain extent. But, the Quick Ratio is less flawed than the Current Ratio.
However, we have provided a comparison chart below to understand both ratios better.
BASIS | CURRENT RATIO | QUICK RATIO |
Definition | The Current Ratio is the ratio that states the proportion of current assets to current liabilities. | A Quick Ratio is a ratio between liquid current assets and current liabilities. |
Synonymous names | The Current Ratio is also known as the working capital ratio. | The Quick Ratio is also known as the acid test ratio. |
Purpose | The Current Ratio helps understand the ability of the firm to take care of its current obligations. | The Quick Ratio helps understand if the firm can take care of urgent requirements when they come up in the future. |
Includes | The Current Ratio includes all current assets and liabilities. | Quick Ratio includes current assets except for the inventory and the prepaid expenses and liabilities except for bank overdraft. |
Optimum Ratio | A Current Ratio of 2:1 is preferred. | A Quick Ratio of 1:1 is preferred. |
Nature | It is liberal when it comes to measuring liquidity. | It is strict in terms of liquidity measurement. |
Appropriate | It is appropriate for all types of firms and businesses. | The Quick Ratio is appropriate for a firm with highly valued inventories. |
The calculation of the acid-test ratio eliminates inventory as it is not necessarily considered liquid because some industries have a difficult time liquidating inventories.
In some cases, inventory might be seasonal and vary accordingly over a yearly period, potentially inflating or deflating the liquidity position. So to curb this very issue, the stock is eliminated from the calculation of the acid-test ratio.
One may overestimate the short-term financial strength due to the colossal inventory base when considering the current ratio. It might be difficult for the current ratio to address this problem where companies continue obtaining loan repayments. So, the acid-test ratio is used for accurate estimation.
The bank overdraft and cash credit are eliminated from current liabilities while calculating the Quick Ratio. This way, it provides a more appropriate picture of a company’s liquidity position.
A stock valuation can be complex as it will not necessarily be at marketable value. As a result, the acid-test ratio remains unfettered as inventory valuation stands void.
Using the acid-test ratio on a standalone basis to determine a company’s liquidity position may not be reliable and sufficient. Other liquidity ratios such as cash flow and current ratios are used simultaneously in conjunction with the acid-test ratio to estimate the complete and accurate liquidity position of the company.
When a company’s debts and obligations fall due, the ratio cannot provide relevant information related to timings and level of cash flows, which is essentially required to estimate the company’s potential in meeting its debts and obligations.
Some businesses can clear off their stagnant inventory at fair market prices. But, this is not applicable in general. Therefore, a stock is excluded from the calculation as it is not considered liquid. Hence, in such cases, a company’s inventory does not qualify as an asset that can be easily converted into cash.
The quick ratio is essential for understanding the financial health of a company.
However, one cannot rely solely on this ratio for a holistic picture of the financial stability of a company.
One should always consider various parameters like the industry of the concerned company or the previous financial records of the company to gain better insights into their investment decisions.
In financial jargon, the acid-test ratio, also known as the quick ratio, uses a firm's balance sheet to evaluate a company's potential to meet its short-term obligations with its current assets and measure its liquidity position.
The formula to calculate the acid-test ratio is:
(Current assets – Inventory – Prepaid expenses ) / Current Liabilities.
The formula stands the same for calculating both quick and acid-test ratios.
Quick ratios are named because of their characteristics of being liquid, the liquid assets available with the company to service the short-term debts and obligations.
A quick ratio is a conservative measure for measuring the short-term liquidity of a company or, in other words, its potential or how quickly it can generate enough cash to clear off all its debts due at a given period.
The preferable ideal quick ratio is 1:1, and that of the current ratio is 2:1, while anything more than one is also considered excellent.
The composition of the current ratio includes existing assets such as account receivables, marketable securities, cash, and cash equivalents, inventory, etc.
In contrast, the composition of the quick ratio includes highly-liquid assets or cash and cash equivalents as a part of current assets.
If both ratios can be the same, a company's inventory and prepaid expenses should be NIL with no bank overdrafts.
Also, it is improbable for a company to have no inventories or zero inventory, and therefore the possibility of both the ratios being the same or equal stands less likely.
In most cases, the ideal current ratio is double that of the quick ratio.
Ideally, a quick ratio is preferable when the value is 1:1, and any number above 1.0 is automatically considered an excellent quick ratio.
Any quick ratio over 1.0 typically indicates that a business's financial/liquidity health holds enough of its accounts to be instantly liquidated for paying off its liabilities.
Other factors that play a significant role in qualifying an excellent quick ratio are management risks involved in a cash crunch, economic turmoil, seasonal industry shortfall in revenues, etc.
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