Quick ratio (also known as asset test ratio) is a liquidity ratio which measures the dollars of liquid current assets available per dollar of current liabilities. Liquid current assets are current assets which can be quickly converted to cash without any significant decrease in their value. Liquid current assets typically include cash, marketable securities and receivables. Quick ratio is expressed as a number instead of a percentage.
Quick ratio is a stricter measure of liquidity of a company than its current ratio. While current ratio compares the total current assets to total current liabilities, quick ratio compares cash and near-cash current assets with current liabilities. Since near-cash current assets are less than total current assets, quick ratio is lower than current ratio unless all current assets are liquid. Quick ratio is most useful where the proportion of illiquid current assets to total current assets is high. However, quick ratio is less conservative than cash ratio, another important liquidity parameter.
Quick ratio is calculated by dividing liquid current assets by total current liabilities. Liquid current assets include cash, marketable securities and receivables.
The following is the most common formula used to calculate quick ratio:
|Quick Ratio||Cash + Marketable Securities + Receivables|
Cash includes cash in hand and cash at bank.
Marketable securities are those securities/investments which can be easily converted to cash, i.e. within a short period of time at a negligible, if any, decrease in its value. Examples include government treasury bills, shares listed on a stock exchange, etc.
Receivables include accounts receivable, notes receivable, etc.
Another approach to calculation of quick ratio involves subtracting all illiquid current assets from total current assets and dividing the resulting figure by total current liabilities. Illiquid current assets are current assets which can’t be easily converted to cash i.e. prepayments, advances, advance taxes, inventories, etc.
|Quick Ratio||Current Assets − Inventories − Prepayments|
Quick ratio is an indicator of most readily available current assets to pay off short-term obligations. It is particularly useful in assessing liquidity situation of companies in a crunch situation, i.e. when they find it difficult to sell inventories.
Prepayments are subtracted from current assets in calculating quick ratio because such payments can’t be easily reversed. Inventories are also excluded because they are not directly convertible to cash, i.e. they result in accounts receivable which in turn results in cash flows and because their net realizable value drops when they are sold in panic situation. Quick ratio’s independence of inventories makes it a good indicator of liquidity in case of companies that have slow-moving inventories, as indicated by their low inventory turnover ratio.
Quick ratio should be analyzed in the context of other liquidity ratios such as current ratio, cash ratio, etc., the relevant industry of the company, its competitors and the ratio’s trend over time. A quick ratio lower than the industry average might indicate that the company may face difficulty honoring its current obligations. Alternatively, a quick ratio significantly higher than the industry average highlights inefficiency as it indicates that the company has parked too much cash in low-return assets. A quick ratio in line with industry average indicates availability of sufficient good quality liquidity.
You are a Financial Analyst tasked to analyze liquidity position of Apple, Inc. (NYSE: AAPL) and Kiwi, Inc. (a fictional futuristic technology company) using quick ratio.
Following is an extract from balance sheet of Apple for the latest period:
|Cash and cash equivalents||21,120|
|Deferred income taxes||5,546|
|Other current assets||23,033|
|Total current assets||89,378|
|Total current liabilities||80,610|
Following information is available regarding Kiwi for the latest complete financial year:
|Total current assets||51,787|
|Deferred income taxes||1,242|
|Other current assets||4,148|
|Total current liabilities||42,191|
Kiwi has an inventory turnover ratio higher than the industry average and a splendid growth rate. Apple’s inventory turnover and growth are in line with industry average.
Amounts other than ratios are in million.
|Quick ratio of Apple =||21,120 + 20,481 + 16,849||= 0.73|
|Quick ratio of Kiwi =||51,787 − 1,242 − 3,485 − 1,116 − 4,148||= 0.99|
Kiwi has a quick ratio of 0.99 as compared to 0.73 in case of Apple. While Apple’s quick ratio is quite safe, Kiwi has better overall liquidity particularly in a crunch situation. Analyzed together with its high growth rate and high inventory turnover ratio, Kiwi’s high quick ratio does not indicate inefficiency either.
Written by Irfanullah Jan