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- The quick ratio evaluates a company's ability to pay its current obligations using liquid assets.
- The higher the quick ratio, the better a company's liquidity and financial health.
- A company with a quick ratio of 1 and above has enough liquid assets to fully cover its debts.
A company's quick ratio is a measure of liquidity used to evaluate its capacity to meet short-term liabilities using its most-liquid assets. A company with a high quick ratio can meet its current obligations and still have some liquid assets remaining.
What is the quick ratio?
Definition and significance
The quick ratio measures a company's ability to pay its short-term liabilities when they come due. It's also called the acid test ratio, or the quick liquidity ratio, because it uses quick assets, or those that can be converted to cash within 90 days or less. This includes cash and cash equivalents, marketable securities, and current accounts receivable.
Why is knowing the quick ratio important?
A quick ratio of 1 is considered the industry average. A quick ratio below 1 shows that a company may not be in a position to meet its current obligations because it has insufficient assets to do so. This tells potential investors that the company in question is not generating enough profits to meet its current liabilities.
On the contrary, a company with a quick ratio above 1 has enough liquid assets to be converted into cash to meet its current obligations. In essence, it means the company has more quick assets than current liabilities.
"The quick ratio is important as it helps determine a company's short-term solvency," says Jaime Feldman, current tax director at Forrest Robinson and former tax manager at Fiske & Company. "It's the company's ability to pay debt due soon with assets that quickly convert to cash. You can use the quick ratio to determine a company's overall financial health."
Calculating the quick ratio
Formula and components
The quick ratio is calculated by dividing the sum of a company's liquid assets by its current liabilities. This is the basic formula:
Quick assets
Quick assets are those that can be quickly turned into cash. Accounts receivable, cash and cash equivalents, and marketable securities are some of the most liquid items in a company.
For an item to be classified as a quick asset, it should be quickly turned into cash without a significant loss of value. In other words, a company shouldn't incur a lot of cost and time to liquidate the asset. For this reason, inventory is excluded from quick assets because it takes time to convert into cash.
Companies usually keep most of their quick assets in the form of cash and short-term investments (marketable securities) to meet their immediate financial obligations that are due in one year.
Current liabilities
Current liabilities are a company's short-term debts due within one year or one operating cycle. Accounts payable is one of the most common current liabilities in a company's balance sheet. It can also include short-term debt, dividends owed, notes payable, and income taxes outstanding.
Example using quick ratio
Let's say you own a company that has $10 million in cash and cash equivalents, $30 million marketable securities, $15 million of accounts receivable, and $22 million of current liabilities. To calculate the quick ratio, divide current liabilities by liquid assets. In this case:
Quick assets = ($10 million cash + $30 million marketable securities + $15 million accounts receivable)
Current liabilities = $22 million
Quick ratio = $55 million / $22 million = $2.5 million.
The company's quick ratio is 2.5, meaning it has more than enough capital to cover its short-term debts.
How to interpret the quick ratio
What different values indicate
Investors who are evaluating liquidity analysis using the quick ratio should keep a few things in mind. A higher quick ratio is generally better, as it points to a company that is more resilient and prepared to cover its short-term obligations. However, interested parties should keep in mind that a very high quick ratio may not be a positive development.
It could mean that a company is highly liquid, or alternatively, it could point to an organization that is not using its resources effectively and could be investing in developments that could bolster its future prospects.
A value of more than 1 indicates that a company has more quick assets than liabilities, meaning that it can likely cover its obligations over the next year using some of its most liquid assets.
On the other hand, a quick ratio below 1 means that a company may have a hard time paying its obligations in the short-term.
Further, it is important to note that quick ratios can vary between industries, so this ratio is more valuable when used to compare companies within the same industry.
Advantages of using the quick ratio
Immediate insight into financial health
One benefit of the quick ratio is that it can provide a quick glimpse of a company's financial status by comparing some of its most liquid assets to its liabilities. Harnessing this ratio, interested parties can quickly compare companies within the same industry.
Comparison with other liquidity ratios
Investors who are looking to perform in-depth assessments of companies can benefit from comparing liquidity metrics in financial analysis. The quick ratio, current ratio, and cash ratio can all be used to measure this kind of financial health.
Quick ratio vs. current ratio
The quick ratio and current ratio are two metrics used to measure a company's liquidity. While they might seem similar, they're calculated differently. The quick ratio yields a more conservative number as it only includes assets that can be turned into cash within a short period 一 typically 90 days or less.
Conversely, the current ratio factors in all of a company's assets, not just liquid assets in its calculation. That's why the quick ratio excludes inventory because it takes time to liquidate.
Quick ratio vs. cash ratio
The cash ratio is another metric used to measure a company's liquidity. This particular metric is an even more conservative measure than the quick ratio that only takes cash and cash equivalents into account.
If a company had to cover its obligations right away, the cash ratio can give you a sense of how easily it could do so without using anything besides cash and cash equivalents.
Limitations of the quick ratio
Potential for misinterpretation
There are several reasons why the quick ratio could be misinterpreted. For one, this ratio does not account for cash flows, which can have a significant impact on a company's liquidity.
Further, it does not take inventory into consideration, and some businesses can liquidate their inventory rather quickly. The impact that inventories have on this ratio may be far more substantial in some industries than in others.
Past that, using the quick ratio alone is not enough to gauge the liquidity of a company, as interested parties should use other means of analysis, for example different liquidity ratios, to provide a more comprehensive assessment.
Contextual factors affecting interpretation
Interested parties should take a company's entire financial situation into account when interpreting its quick ratio. For example, an organization might have significant long-term debt. Should interest rates push higher, such a business might have a hard time meeting its long-term debt obligations. In such a scenario, a company's quick ratio may not be as helpful in assessing its financial health.
When evaluating a specific business using the quick ratio, it can prove helpful to get a sense of that organization's quick ratio history, meaning how this measure has changed over time.
The quick ratio in different industries
Variability across sectors
Quick ratios can vary significantly between different industries, which is why some recommend using this measure to compare companies within the same industry.
Potential investors can also benefit from examining industry benchmarks for the quick ratio. Some sectors, for example biotechnology and medical instruments & supplies, have particularly high quick ratios. As of April 2024, the former industry had an average quick ratio of over 4.5, while the latter had a quick ratio of 2.78. Discount stores provided a contrast, as they had an average quick ratio of 0.3.
Conclusion
The quick ratio evaluates a company's capacity to meet its short-term obligations should they become due. This liquidity ratio can be a great measure of a company's short-term solvency. As an investor, you can use the quick ratio to determine if a company is financially healthy. "The higher the ratio result, the better a company's liquidity and financial health is," says Feldman.
However, it's essential to consider other liquidity ratios, such as current ratio and cash ratio when analyzing a great company to invest in. This way, you'll get a clear picture of a company's liquidity and financial health.
FAQs
How is the quick ratio different from the current ratio?
The quick ratio does not include inventory, while the current ratio does, providing a less conservative, but more comprehensive, measure of a company's liquidity.
What does a quick ratio of less than 1 indicate?
A quick ratio below 1 signals that a company may not have enough liquid assets to cover its liabilities, pointing to potential liquidity problems.
Can a high quick ratio be seen as a negative sign?
While a high quick ratio is generally viewed positively, a ratio that is too high may point to a company that is not using its resources effectively.
How often should the quick ratio be calculated?
Interested parties can calculate a company's quick ratio as needed. They might want to evaluate it on a quarterly or annual basis to coincide with regular financial reporting.
Is the quick ratio applicable to all companies?
The quick ratio can be used to evaluate all companies. However, its relevance may vary based on the industry in question, as some industries make significant use of inventories.
Lydia Kibet is a freelance writer with a knack for personal finance, investing, and all things money. She's passionate about explaining complex topics in easy-to-understand language. Her work has appeared in Business Insider, Investopedia, The Motley Fool, and GoBankingRates. She currently writes about personal finance, insurance, banking, real estate, mortgages, credit cards, loans, and more. Connect with her atlydiakibet.comorLinkedIn.
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