Quick Ratio

Quick ratio or Acid Test ratio is the ratio of the sum of cash and cash equivalents, marketable securities and accounts receivable to the current liabilities of a business. It measures the ability of a company to pay its debts by using its cash and near cash current assets (i.e. accounts receivable and marketable securities).

Formula

Quick ratio is calculated using the following formula:

Quick Ratio
 = Cash + Marketable Securities + Receivables
Current Liabilities

Marketable securities are those securities which can be coverted into cash quickly. Examples of marketable securities are treasury bills, saving bills, shares of stock-exchange, etc. Receivables refer to accounts receivable. Alternatively, quick ratio can also be calculated using the following formula:

Quick Ratio
 = Current Assets − Inventory − Prepayments
Current Liabilities

Analysis

Quick ratio measures the liquidity of a business by matching its cash and near cash current assets with its total liabilities. It helps us to determine whether a business would be able to pay off all its debts by using its most liquid assets (i.e. cash, marketable securities and accounts receivable).

A quick ratio of 1.00 means that the most liquid assets of a business are equal to its total debts and the business will just manage to repay all its debts by using its cash, marketable securities and accounts receivable. A quick ratio of more than one indicates that the most liquid assets of a business exceed its total debts. On the opposite side, a quick ratio of less than one indicates that a business would not be able to repay all its debts by using its most liquid assets.

Thus we conclude that, generally, a higher quick ratio is preferable because it means greater liquidity. However a quick ratio which is quite high, say 4.00, is not favorable to a business as whole because this means that the business has idle current assets which could have been used to create additional projects thus increasing profits. In other words, very high value of quick ratio may indicate inefficiency.

Examples

Example 1: A company has following assets and liabilities at the year ended December 31, 2009:

Cash$34,390
Marketable Securities12,000
Accounts Receivable56,200
Prepaid Insurance9,000
Total Current Assets111,590
Total Current Liabilities73,780

Calculate quick ratio (acid test ratio).

Solution
Quick ratio = ( 34,390 + 12,000 + 56,200 ) / 73,780 = 102,590 / 73,780 = 1.39
   OR
Quick ratio = ( 111,590 − 9,000 ) / 73,780 = 102,590 / 73,780 = 1.39

Example 2: Calculate quick ratio from the following information:

Cash$21,720
Treasury Bills18,500
Accounts Receivable15,930
Prepaid Rent6,500
Inventory17,240
Total Current Assets79,890
Total Current Liabilities52,960

Solution
In this example, treasury bills are marketable securities thus we will calculate quick ratio as follows:
Quick ratio = ( 79,890 − 6,500 − 17,240 ) / 52,960 = 56,150 / 52,960 = 1.06
   OR
Quick ratio = ( 21,720 + 18,500 + 15,930 ) / 52,960 = 56,150 / 52,960 = 1.06

Written by Irfanullah Jan