The quick ratio is a measure of a company's short-term liquidity and indicates whether a company has sufficient cash on hand to meet its short-term obligations. The higher a company’s quick ratio is, the better able it is to cover current liabilities.
This article will explain the quick ratio, provide the formula for calculating it with an example, and discuss how the quick ratio is different from the current ratio.
Definition and Examples of the Quick Ratio
The quick ratio provides a simple way of evaluating whether a company can cover its short-term liabilities very quickly. This is important for a business because creditors, suppliers, and trade partners expect to be paid on time.
Investors will use the quick ratio to find out whether a company is in a position to pay its immediate bills.
Because of its focus on assets that are immediately available to meet short-term obligations, the quick ratio is also known as the “acid test ratio.”
The formula for calculating the quick ratio is quick assets/current liabilities. Quick assets are a subset of current assets that can more readily be converted into cash with minimal loss in value. Examples of quick assets include cash, marketable securities, and accounts receivable.
Quick assets can also be thought of as current assets excluding inventory. That’s because sometimes, inventory may be difficult to liquidate quickly enough, or it has an uncertain liquidation value, so it isn’t clear if it can be converted in time—or how much cash it will provide. For that reason, the quick ratio formula is often written as: (current assets - inventory)/current liabilities.
Current liabilities are financial obligations that the firm must pay within a year.
As an example of the quick ratio, let's assume a company has the following current assets:
Now, assume current liabilities are $350,000.
The firm's quick ratio is: ($50,000 + $50,000 + $400,000) / $350,000 = $500,000/$350,000 = 1.43
That means that the firm has $1.43 in quick assets for every $1 in current liabilities. So the company has adequate liquidity to pay its short-term bills. Any time the quick ratio is above 1, then quick assets exceed current liabilities.
If the quick ratio is less than 1, the firm does not have sufficient quick assets to pay for current liabilities.
For example, from the illustration above, assume that the firm's current liabilities are instead $600,000. The quick ratio would be: $500,000/$600,000 = 0.83
Types of Financial Ratios
The quick ratio is just one ratio used for analyzing the performance or financial position of a company. There are many more financial ratios, and they can be categorized into types based on their function. The main categories of financial ratios are:
- Profitability: These ratios measure the firm's ability to generate a return. Examples include profit margin, return on assets, and return on equity.
- Asset utilization: Asset utilization ratios measure how effective the firm is at selling its inventory, collecting its receivables, and employing its fixed assets.
- Liquidity: These ratios, the quick and current, measure the firm's ability to pay its short-term financial obligations.
- Debt utilization: These assess the firm's debt position relative to its assets and earnings.
Quick Ratio vs. Current Ratio
The quick ratio and current ratio are very similar. They are both liquidity ratios that assess a firm's ability to meet any financial obligations that will be due within one year.
However, the quick ratio is the more conservative measure of the two because it only includes the most-liquid assets in the calculation. The current ratio measures the firm's near-term liquidity relative to the firm's total current assets, including inventory.
|Current Ratio||Quick Ratio|
|Includes all current assets||Includes only the most-liquid current assets|
|Measures short-term liquidity||More conservative measure of short-term liquidity|
Taking the same information from the example above, we can calculate the firm's current ratio by simply including the inventory: ($50,000 + $50,000 + $400,000 + $450,000)/ $350,000 = 2.7
What It Means for Individual Investors
Because the quick ratio is a measure of how well a company is positioned to meet its financial obligations, it can be an important metric for determining a company’s financial well-being. An illiquid firm that can’t pay its short-term bills may not remain in business.
How To Find a Firm's Quick Ratio
To calculate a firm's quick ratio, you can look at the most recently reported balance sheet from a company to get the quick assets and current liabilities because the purpose of the balance sheet is to list all the firm's assets and liabilities. You can then pull the appropriate values from the balance sheet and plug them into the formula.
Companies will often post their quarterly and annual financial reports, including their balance sheets, on their websites. You also can search for annual and quarterly reports on the Securities and Exchange Commission website.
- The quick ratio measures short-term liquidity.
- It does not include inventory in the calculation, so it’s more conservative than the current ratio.
- Quick ratio is one of many financial ratios used for evaluating firms.
- Values can be taken from the balance sheet in the company's most recent financial filing to calculate the quick ratio yourself.