What Is the Quick Ratio?

What Is the Quick Ratio?

Let me explain the quick ratio directly to you: it measures a company's ability to meet its short-term obligations right away using its most liquid assets. I use this to evaluate the strength of a company's cash position. You might hear it called the acid test ratio.

Key Takeaways

The quick ratio shows a company's capacity to pay current liabilities without borrowing. It's more conservative than the current ratio, which includes all current assets. You calculate it by dividing the most liquid assets—like cash, cash equivalents, marketable securities, and accounts receivable—by total current liabilities. A higher ratio means better financial health; a lower one suggests struggles with debts.

Formula for the Quick Ratio

Here's how you calculate the quick ratio: add up the most liquid assets and divide by current liabilities. Quick assets are the most liquid current assets that convert easily to cash. For most companies, that means cash plus cash equivalents plus marketable securities plus net accounts receivable.

You can also calculate quick assets by subtracting illiquid items from total current assets, like inventory and prepaid expenses. Either way, current liabilities stay the same—all of them count in the formula.

What the Quick Ratio Can Tell You

The quick ratio tells you the dollar amount of liquid assets against current liabilities. Liquid assets convert quickly to cash with little price impact, and current liabilities are debts due within a year.

If the ratio is less than one, the company might not cover liabilities short-term. A ratio over one means it can pay them off instantly. For example, a 1.5 ratio means $1.50 in liquid assets per $1 of liabilities. Remember, this is just one insight—look at other measures for the full financial picture.

Components of the Quick Ratio

Cash is straightforward—reconcile it with bank statements, including translated foreign cash. Cash equivalents are low-risk, high-liquidity investments like Treasury bills or commercial paper. Note that cryptocurrencies don't count as cash or equivalents.

Marketable securities should only include those receivable in 90 days or less without penalties. Net accounts receivable depend on credit terms—shorter terms improve liquidity. Reduce the balance by uncollectible amounts. Current liabilities include all short-term debts like accounts payable and taxes payable.

Quick Ratio vs. Current Ratio

The quick ratio is more conservative because it excludes inventory and prepaid expenses, which are harder to turn into cash. The current ratio includes them. In most cases, inventory doesn't liquidate quickly, and prepaid expenses can't pay liabilities.

Advantages and Disadvantages of the Quick Ratio

On the advantages side, it's a conservative estimate of liquidity and easy to calculate from the balance sheet. You can use it to compare companies over time or across sectors.

Disadvantages include not considering future cash flows or long-term liabilities. It might overstate collectability of receivables or liquidity of securities in downturns.

Example of How to Use the Quick Ratio

Public companies report this in their key ratios. Take two competitors, ABC and XYZ: ABC has quick assets of $15,013 million and liabilities of $33,132 million, giving a ratio of 0.45. XYZ has $46,891 million in quick assets and $45,226 million in liabilities, for a 1.04 ratio. XYZ can cover its liabilities; ABC might not.

Explain Like I'm 5

The quick ratio checks if a company has enough quick cash to pay short-term bills, using things like bank money and incoming payments, without selling inventory. Higher means stronger position; lower means potential trouble.

Why Is It Called the Quick Ratio?

It's called that because it focuses on assets that convert quickly to cash for paying short-term debts.

Why Is the Quick Ratio Important?

It shows if a company can pay short-term debts with liquid assets, signaling cash risks to management and investors. It's more conservative than other ratios.

Is a Higher Quick Ratio Better?

Generally yes, as it means more liquid assets than liabilities. But too high might mean unused cash that could grow the business.

How Do the Quick and Current Ratios Differ?

Quick ratio uses only most liquid assets; current includes inventory and prepaid expenses, making quick more conservative.

What Happens If the Quick Ratio Indicates a Firm Is Not Liquid?

Even healthy companies can face crises if they can't meet obligations, like in the 2007-08 credit crunch, leading to asset sales or bankruptcy.

The Bottom Line

Companies need cash flow to pay bills. The quick ratio shows short-term resources if liquidation is needed. It's aggressive in assessing liquidity.