A quick ratio tests a company’s current liquidity and solvency. It is a measure of whether the company can pay its short-term obligations with its cash or cash-like assets on hand. (Short term obligations are generally defined as any liability due within the next year.) The quick ratio, sometimes known as the “acid test ratio” or the “liquidity ratio,” is considered an important measure of a company’s financial strength.
Quick Ratio Defined
The quick ratio measures how well a company can meet its short-term liabilities (such as debts payment, payroll, inventory costs, etc.) with its cash on hand. In this case “cash” is defined as either actual cash or cash-like assets which can quickly be converted. Cash-like assets are traditionally defined as liquid properties that the company can easily sell off, such as stocks, or near-term revenue, such as accounts due for collection. These are the company’s “quick” assets, giving the quick ratio its name.
The quick ratio, then, is defined as the ratio of all liabilities due within the next year measured against all liquid assets or revenue due within the next year.
Understanding the Quick Ratio
The quick ratio (QR) is calculated through the following formula:
QR = (Cash and Cash Equivalent + Liquid Securities + Accounts Receivable) / Short-Term Liabilities
- Cash and cash equivalents are any assets that are either cash or essentially treated as cash;
- Liquid securities are securities that the company can sell with few restrictions, such as stocks and bonds;
- Accounts receivable are debts the company will collect within the next year;
- And short-term liabilities are any debts, obligations or accounts that the company must make payment on within the next year.
A quick ratio of 1.0 is considered good. It means that the company has enough money on hand to pay its obligations.
A ratio higher than 1.0 means that the company has more money than it needs. For example, a ratio of 2.0 means that the company has $2 on hand for every $1 it owes. This is generally good, as it means that the company can easily make payments on any of its debts. However, an excessively high quick ratio might, in some cases, indicate that the company may not be using its money wisely, choosing to hold onto cash that it could otherwise reinvest in the business.
Investors are concerned with a quick ratio less than 1.0. This means that the company owes more money in short-term liabilities than it has in 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 that the company has or can raise 75 cents for every dollar it owes over the next 12 months.
The quick ratio can provide a good snapshot of company’s health, but it can also miss important issues. For example, the ratio incorporates accounts receivables as part of a company’s assets. This is important because leaving this information out can give a false impression, making the company seem financially weaker than it actually is. However, this depends on the company’s clients making their payments in a timely fashion. If a client doesn’t make their payments on time, the company may not have the cash flow that the quick ratio indicates.
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 allow for variable times or forms of payment, or the company may have access to credit and refinancing options. None of this would be reflected in the quick ratio.
Finally, note that a company’s liquid securities are an element of its short-term assets. The quick ratio formula uses the current market price of those securities, but these prices will change. A company’s quick ratio reflects the market price of its securities at the time of the calculation, which means that as time goes on the calculation gets less accurate.
Quick Ratio Example
Take a sample company ABC Corp. This company has the following short-term assets:
- Cash/cash equivalent: $10 million
- Stock 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 in a total amount of $40 million.
As a result, ABC Corp. has the following quick ratio:
- QR = ($10 million + $8 million + $15 million) / $40 million
- QR = $33 million / $40 million
- QR = 0.825
This is not a great quick ratio. It indicates that ABC Corp. may not have enough money to pay all of its bills in the coming months, having 85 cents in cash for every dollar it owes. This should cause concern in any potential investors.
The Bottom Line
The quick ratio is a measure of a company’s financial position. It calculates the ratio of a company’s cash and liquid assets against its short-term liabilities to give investors a sense of how easily the company can pay its upcoming bills. This ratio can signal that a company may lack liquidity or that it is not wisely deploying its cash and other liquid assets. Keep in mind that not all accounts receivable are created equal: money due from one customer may not arrive in as timely a fashion due from another customer. Anticipating delays and also leaving room for the market value of short-term assets to fluctuate will make for a more accurate quick ratio.
Tips for Investors
- You don’t have to make these money management and investing decisions alone. A financial advisor experienced in these matters can be invaluable. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool can match you up with several advisors in your area quickly. If you’re ready, get started now.
- The quick ratio is one tool in a financial analyst’s toolkit. There are many others. A survey of these basic tools for analyzing a company can help you be a more successful investor.
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