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A quick ratio is a financial ratio that compares the current assets to the current liabilities. It can be used as an indicator of liquidity and solvency because it shows how quickly a company could pay off its liabilities.
The quick ratio is a formula that can be used to determine the quick assets of a company. It is calculated by dividing current assets by current liabilities.
What is the Quick Ratio and How Does It Work?
The quick ratio, like the current and cash ratios, is a liquidity ratio that compares a company’s current assets to current liabilities to determine its short-term financial health. The quick ratio is used by a company’s stakeholders, including investors and lenders, to determine whether it can fulfill its short-term commitments without selling fixed assets or liquidating inventories.
The formula for a Quick Ratio
The quick ratio formula divides a company’s current assets by its current liabilities, excluding inventory. Current assets are liquid assets such as cash and cash equivalents, while current liabilities are short-term obligations such as accumulated salary and payroll taxes.
The formula for a rapid ratio is as follows:
Cash + Cash Equivalents + Marketable Securities + Accounts Receivable (A/R) / Liabilities in the Present = Quick Ratio = Cash + Cash Equivalents + Marketable Securities + Accounts Receivable (A/R) / Current Liabilities
Assets in Use
Any balance sheet assets that may be converted to cash within 90 days are considered current assets. Cash and cash equivalents are examples of liquid assets. Current assets include accounts receivable and marketable securities, which are usually believed to be convertible to cash within 90 days.
The following are some instances of current assets:
- Cash includes money in checking and savings accounts, as well as coins and currency, petty cash, money orders, and bank drafts.
- Treasury bills, money market funds, short-term government bonds, commercial paper, and securities are all examples of cash equivalents, which are highly liquid, short-term investment instruments.
- A/R stands for accounts receivable, which refers to money owed to a business by consumers in return for supplied products or services. A/R is usually due within 90 days, making it a highly liquid asset.
What Isn’t Counted Among Current Assets?
Current assets exclude any assets that are not usually converted to cash within 90 days and therefore have no effect on a company’s fast ratio. This includes inventory, since it is expected that selling off all goods within 90 days without discounting and perhaps selling at a loss would be challenging. All other excluded assets are classified as fixed assets, which include property, equipment, and vehicles that are not sold or otherwise consumed by a company during regular operations.
The following are some instances of assets that are not included in current assets:
- Property; any buildings, land, or other real estate owned by a company.
- Any machinery; technology such as computers and servers, and other equipment not considered part of the company’s inventory is termed equipment.
- Vehicles: Any automobiles, trucks, or other titled vehicles held by a business but not included in its inventory are called vehicles.
Current Liabilities
All short-term financial commitments that a business must pay immediately or within one year are classified as current liabilities. Liabilities include short-term loans, current long-term debt maturities, accounts payable (A/P), wages, and taxes.
The following are some instances of current liabilities:
- A/P: Any commitments to repay creditors, merchants, and suppliers for short-term debt.
- Sales taxes; income taxes, and payroll taxes are all examples of taxes.
- Payroll; Money due to workers, such as salaries, wages, bonuses, and commissions.
- Any short-term loans or current maturities of long-term obligations of current loan liabilities.
What isn’t covered by Current Liabilities?
Long-term debt, such as commercial real estate loans, Small Company Administration (SBA) loans, and most business debt consolidation loans, are excluded from current liabilities since they are not due within one year.
What Is a Quick Ratio and How Do I Interpret It?
In general, the greater a company’s quick ratio, the more likely it is to be able to pay its short-term obligations. A ratio of greater than one-to-one indicates that a company’s current assets are sufficient to cover all of its current liabilities, whereas a ratio of less than one-to-one indicates that the company will be unable to meet its current liabilities without increasing sales, selling fixed assets, or inventory, or raising capital in some other way.
What Is an Appropriate Quick Ratio?
The kind of business and industry determine whether a firm has a high fast ratio. Furthermore, a company’s quick ratio is always changing as current assets such as cash on hand and current obligations such as short-term debt and payroll fluctuate. As a consequence, many businesses attempt to maintain their quick ratio within a given range rather than aiming for a specific figure.
A fast ratio of at least one-to-one is usually seen as desirable, with the optimum goal for a company’s quick ratio lying somewhere between 1.2-to-1 and 2-to-1. Anything below one suggests that a business will struggle to fulfill current obligations, while anything over two shows that a company is not actively investing its present assets.
The Importance of the Quick Ratio
The quick ratio gives a conservative picture of a company’s financial health and assists investors, lenders, and other stakeholders in determining a company’s capacity to pay short-term commitments promptly. The fast ratio is often used by financial institutions to evaluate whether or not to provide credit to a business, while investors may use it to determine whether or not to invest money, as well as how much to invest.
The quick ratio is widely used by corporate finance experts and investment analysts to evaluate the health of publicly listed firms, and it is considered an essential tool by both businesses and bankers to gauge a company’s financial well-being. The quick ratio, as well as other liquidity measures, may help small companies evaluate their financial health.
Other Liquidity Ratio Examples
It’s usually a good idea to use various ratios to figure out how a company is doing right now. Small company owners should also think about current and cash ratios since both are popular options that operate in tandem with the quick ratio.
Current Ratio vs. Quick Ratio
A common alternative to the quick ratio is the current ratio, often known as the working capital ratio. The definition of current assets differs between the two ratios. The current ratio is calculated using current assets, which are assets that may be converted to cash within a year.
The quick ratio solely considers current assets that may be converted to cash in less than 90 days, excluding inventories. One of the most frequent criticisms of the current ratio is that it undervalues the difficulties of converting inventory to cash without selling it below market value and possibly at a loss.
Cash Ratio vs. Quick Ratio
Another liquidity measure is the cash ratio, which is used to evaluate a company’s short-term financial health by comparing current assets to current liabilities. Because it removes both inventories and accounts receivable from current assets, it is considered the most cautious of similar ratios.
The cash ratio is based on the premise that inventory and accounts receivable are difficult to collect and should not be included among liquid assets since doing so would falsely exaggerate a company’s capacity to pay its debt commitments in the near term. It has been criticized for its conservative assessment of stability, which fails to account for companies that are good at selling through inventory and collecting on accounts receivable.
The Benefits and Drawbacks of Using the Quick Ratio
The fast ratio is one of many liquidity ratios that may be used to assess a business’s short-term financial health. Its simplicity and conservative attitude are two of its advantages. It cannot give correct information about cash flow timing, and it may not effectively account for A/R values, among other drawbacks.
Advantages of the Quick Ratio
- Simplicity: The fast ratio aids a company’s understanding of its liquidity, allowing them to assess their company’s short-term financial health.
- When compared to the current ratio, the quick ratio is considered a conservative way of evaluating the company’s liquidity since inventory is not included in the calculation.
Drawbacks
- Cash flow timing: The fast ratio does not give precise information on cash flow timing.
- A/R: The quick ratio implies that a business’s accounts receivable may be collected at any moment, which is never the case. In addition, owing to early payment incentives and other agreements, the A/R value may be lower than the book value.
While the acid test may be a useful tool for businesses looking to assess their short-term health, as well as investors, lenders, and other stakeholders, its limitations mean that utilizing the ratio on its own may not be adequate to assess the company’s actual liquidity situation.
How to Boost Your Quick Ratio
A business with a greater quick ratio than one with a lower quick ratio is seen to be more financially solid. A quick ratio of more than one is considered to be “healthy.” Companies, as well as their creditors, lenders, investors, capitalists, and other stakeholders, benefit from having a good fast ratio. Businesses should constantly keep a close eye on their quick ratio.
Increased sales and inventory turnover, improve invoice collection time, and paying off obligations as soon as possible are three of the most frequent methods to enhance the quick ratio.
1. Increase inventory turnover and sales
Increasing sales is one of the most frequent ways to improve liquidity ratios. Discounting, enhanced promotion, and motivating sales personnel are all methods that may be utilized to improve sales and, as a result, inventory turnover. Inventory is not included in the quick ratio calculation, as previously stated. This implies that in order for inventory to become a more liquid asset, it must first be actively sold in order to convert it to cash.
2. Shorten the time it takes to collect invoices
Reducing the amount of time it takes to collect accounts receivable has a direct and beneficial effect on a company’s quick ratio. It may assist increase a company’s incoming cash flow if the collecting time is shorter. Long-term borrowers, sticky debtors, and bad debts are less likely to be encountered. Setting explicit invoice conditions at the start of every transaction, as well as pursuing aggressive collection efforts, will have a direct effect on a company’s quick ratio.
3. Pay Off Your Debts As Soon As Possible
Improving the quick ratio requires keeping the company’s obligations under control. The fast ratio’s denominator is current liabilities, and keeping them low will put your company in a better position. This may be accomplished by paying off creditors as quickly as possible and shortening the maturities of company loans.
Conclusion
Although the quick ratio does not give an accurate picture of a company’s overall financial health, it may be useful in determining the company’s short-term financial condition. It determines if a company’s existing assets are adequate to meet its immediate financial commitments. As a result, it’s critical to keep an eye on your quick ratio and make sure your funds are in order.
