Quick ratio: definition, formula and use

A quick ratio tests the current liquidity and creditworthiness. It is a measure of the company’s ability to pay its short-term obligations with its cash or cash-like assets. (Short-term bonds are generally defined as any liability due in the next year.) The quick ratio, sometimes referred to as the “acid test ratio” or “liquidity ratio,” is considered an important measure of strength. financial of a company.

Quick ratio defined

The quick ratio measures how well a business can meet its short-term obligations (such as paying debts, payroll, inventory costs, etc.) with their cash on hand. In this case, “cash” is defined as real cash or cash-like assets that can be quickly converted. Cash-like assets are traditionally defined as liquid assets that the business can easily sell, such as stocks, or short-term income, such as accounts receivable. These are the “quick” assets of the company, hence its name.

The quick ratio, then, is defined as the ratio of all liabilities due in the following year measured against all liquid assets or income due in the following year.

Understanding the Quick Report

The quick ratio (QR) is calculated using the following formula:

QR = (Cash and cash equivalents + Liquid securities + Accounts receivable) / Short-term liabilities

Or:

• Cash and cash equivalents are all assets that are either cash or primarily treated as cash;

• Liquid securities are securities that the company can sell with few restrictions, like actions and obligations;

• Accounts receivable are debts that the business will collect over the next year;

• And short-term debts are any debts, obligations, or accounts the business has to pay off over the next year.

A quick ratio of 1.0 is considered good. This means that the company has enough the money available to pay its obligations.

A ratio greater than 1.0 means the business has more money than it needs. For example, a ratio of 2.0 means the business has $ 2 on hand for every $ 1 it owes. This is generally good, as it means that the business can easily make payments on any of its debts. However, an excessively high Quick Ratio can, in some cases, indicate that the business may not be using its money wisely, choosing to keep cash that it could otherwise reinvest in the business.

The story continues

Investors are concerned with a rapid ratio below 1.0. This means that the company owes more money in short-term debt than he has cash, potentially indicating that the company cannot pay all of its bills in the coming months. For example, a quick ratio of 0.75 means the business has or can raise 75 cents for every dollar it owes over the next 12 months.

The quick ratio can provide a good insight into the health of the business, but it can also miss important issues. For example, the ratio incorporates accounts receivable into the assets of a business. This is important because omitting this information can give the wrong impression, making the business appear financially weaker than it actually is. However, it depends on the business customers making their payments on time. If a customer does not make their payments on time, the business may not have the cash flow indicated by the quick ratio.

Or, on the other hand, the company may have more options to manage its debt than the quick ratio indicates. For example, a liability may have varying payment terms or methods, or the business may have access to credit. and refinancing options. None of this would be reflected in the quick ratio.

Finally, it should be noted that the liquid securities of a company are an element of its current assets. The quick ratio formula uses the current market price of these securities, but those prices will change. A company’s quick ratio reflects the market price of its securities at the time of the calculation, which means that over time the calculation becomes less accurate.

Sample quick report

Take the example of ABC Corp. This company has the following current assets:

• Cash / cash equivalent: $ 10 million

• Equity portfolio: $ 8 million

• Accounts receivable: $ 15 million

It has short-term liabilities such as debt payment, payroll, and inventory costs due within the next 12 months totaling $ 40 million.

As a result, ABC Corp. has the following rapid ratio:

This is not a good quick report. He indicates that ABC Corp. might not have enough money to pay all of her bills over the next few months, having 85 cents in cash for every dollar she owes. This should worry with any potential investor.

The bottom line

The quick ratio is a measure of the financial condition of a business. It calculates the ratio of a company’s cash and liquid assets to its current liabilities to give investors an idea of ​​how easily the company can pay its upcoming bills. This ratio can signal that a business may be running low on cash or not wisely deploying cash and other liquid assets. Keep in mind that not all accounts receivable are created equal: money owed by one customer may not arrive on time as owed by another customer. Anticipation of delays and the possibility of fluctuation in the market value of short-lived assets will result in a faster, more accurate ratio.

Advice to investors

• You don’t have to make these money management and investing decisions on your own. A financial advisor with experience in these areas can be invaluable. Finding a financial advisor doesn’t have to be difficult. The free tool of SmartAsset can quickly put you in touch with several advisers in your area. If you are ready, start now.

• The Quick Ratio is a tool in a financial analyst’s toolbox. There are many more. A overview of these basic tools to analyze a business can help you be a more successful investor.

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