Quick ratio indicates the short term liquidity position of a company and makes a measurement of the ability of the company to meet requirements that are short term with the assets which are most liquid.
It includes those assets which quickly or immediately convert into cash within a period of 90 days.
It is also known as the acid test as it gives out instantaneous, quick results.
How can we understand Quick Ratio?
The ratio 1:1 is known as the ideal quick ratio and it stands to say that there are enough assets that can be liquidated instantly in the business to pay off the current liabilities.
When the quick ratio is less than 1, the company cannot fully pay off the current outstanding liabilities that are present in this short term period.
If the ratio is above 1, it retains these liquid assets in order to immediately discharge the current liabilities that are available.
How to Calculate Quick Ratio?
The formula for Quick Ratio is,
QR= CE+AR+MS / CL
Or
QR= CA−I−PE / CL
QR stands for Quick ratio
MS is for Marketable Securities
CE is Cash & equivalents
AR means Accounts Receivable
CL stands for Current Liabilities
CA is Current Assets
I denotes Inventory
PE is Prepaid Expenses
A result of 1:1 is known to be the ideal quick ratio.
While calculating the Quick Ratio, the components from the formula which are present in the balance sheet need to be used in the equation.
In the numerator, only the assets which can be converted into cash for a short term basis which is mainly within 90 days should be present without any changes in the price.
In order to calculate the quick ratio, we will exclude inventory and prepaid expenses from our quick ratio.
We actually exclude inventory because the inventory takes time in converting into cash as it is a slow moving asset. Inventory is in various different forms where it could be in the form of a raw material, it could be work in progress or as a finished product and this basically goes to state that we don’t know when our raw materials will be converted into finished goods and when these final goods will be sold to the customers.
This is why the inventory is excluded as it takes too much time in converting into liquid form and the quick assets are those which quickly and immediately get converted into cash.
An Example for Quick Ratio would be,
Cash = Rs. 20000
Inventory = Rs. 10000
Accounts Receivable = Rs. 10000
Stock Investments = Rs. 2000
Prepaid Expenses = Rs. 1000
Current Liabilities = Rs. 30000
The Quick Ratio would be,
20000 + 2000 + 10000 / 30000
= 32000 / 30000
= 1.06
This ratio indicates that the liquid assets and the current liabilities can be paid off at disposal with some remaining assets as well.
What are the Benefits of Quick Ratio?
- This ratio helps measure how current assets can pay off current liabilities in an accurate manner.
- Quick ratio is simple and straightforward which makes it easy to use for all kinds of users, especially those who don’t have any financial or accounting background.
- Inventories are excluded from this ratio and this can assist the management, shareholders, investors in gaining accurate information to assess the current liquidity position of the business.
- The current assets and liabilities can be compared and the results are measured in percentage terms. This means that it can be compared with other competitors as well.
- This ratio would allow businesses to have a stable repayment level as compared to the present ratio which includes inventory within it when it comes to diminishing markets where there is a huge amount of inventory.
- The ratio is made in a much more reasonable manner as the cash credit and bank overdraft is excluded and removed from it.
- It works well with seasonal changes for the businesses as inventory is not taken into consideration.
What are the Limitations of using Quick Ratio?
- This ratio is not good enough to make conclusions when it comes to the financial health of the company. Even if the ratio may be low, this does not necessarily mean that the company will liquidate as there could be other sources to fund operations.
- For comparing across different industries, it is not useful as this ratio will not convey much to us.
- By excluding the ratio from the companies, the big picture when it comes down to it, will not fully be shown or displayed.
- It does not portray or show anything regarding the cash flow of the company as there is no related data which is available.
- It takes accounts receivables as liquid which can be converted into cash easily and this may not continuously be the case.
- If higher inventory is present within a company, this ratio would not be the right indicator to show short term solvency.
A commerce graduate who is on a mission to educate people about investment and personal finance.