What is quick ratio and how is it calculated?

Having ways to understand the financial position of your business is key to knowing how your business is doing. Find out about the quick ratio and how it can help you manage the risk that your business won’t have enough cash to pay its debts on time (your liquidity risk).

Ways to measure a business’s liquidity

A business’s liquidity measures its spending power and essentially shows a business’s ability to cover its immediate costs and financial obligations. Liquid assets are assets that can quickly and easily be converted into cash. Liquidity is important for a business to cover short-term costs without incurring costly interest payments on short-term loans.

Three different ratios can be used to measure a business’s liquidity:

• Current ratio
• Cash ratio
• Quick ratio

Current ratio: This is the easiest, least complicated, and most commonly used ratio. It calculates a business’s current assets ( can be converted into cash within one year) against total current liabilities. It is different from the quick ratio in that it uses all current assets, unlike the quick ratio.

Current ratio = Current assets ÷ Current liabilities

Cash ratio: In this formula, liquid assets are only cash or cash equivalents. The purpose of this ratio is to measure the worst-case ability of a business to remain solvent and pay its bills.

Cash ratio = Cash and cash equivalents ÷ Current liabilities

Quick ratio: The quick ratio, often called the acid test ratio, only uses assets that can be changed into cash within three months. The formula to find a business’s quick ratio is to divide its liquid assets by its current liabilities. These two versions use slightly different ways of calculating liquid assets.

Quick ratio = (Cash + Cash equivalents + Short-term investments + Accounts receivable) ÷ Current liabilities

Quick ratio = (Current assets – Inventory – Prepaid expenses) ÷ Current liabilities

What is the quick ratio?

The quick ratio assesses a business’s short-term liquidity against its short-term debt. It’s a more conservative way to measure liquidity because it considers fewer items. One of the main objectives of the quick ratio is to determine if a business’s short-term (or current) liabilities are less than its liquid assets.

The people most likely to use the quick ratio are accountants, especially those involved in budgeting. Investors and lenders can also be interested in examining it, as a tool in a business’s financial management.

The quick ratio formula

To find a business’s quick ratio, we divide its liquid assets by its current liabilities. These two versions calculate liquid assets differently.

Quick ratio = (Cash + Cash equivalents + Short-term investments + Accounts receivable) ÷ Current liabilities

This version is a bit stricter as it doesn’t take current assets or inventory into account.

Quick ratio = (Current assets – Inventory – Prepaid expenses) ÷ Current liabilities

This variation is less strict as it subtracts inventory from current assets. It’s often used when financial statements don’t provide a breakdown of your quick assets. Inventory is considered an illiquid asset meaning it can’t be converted to cash quickly.

A quick ratio higher than 1 may be considered to be a reduced financial risk. A quick ratio of less than 1 may be regarded as implying a higher financial risk.

Features of the quick ratio

The quick ratio features the following types of liquid assets:

• Cash: Banknotes and coins that can be accessed quickly.
• Cash equivalents: Securities used for short-term investments. Examples include Treasury Bills, commercial papers, and certificates of deposit.
• Prepaid expenses: Future expenses that are paid ahead of time. Examples include rent and insurance.
• Marketable securities: Financial assets that can easily be bought and sold via a public market. Examples include stocks and bonds.
• Net accounts receivable: The total amount of money owed by customers to your business.

Advantages of the quick ratio

• An advantage of the quick ratio is that it’s a traditional estimate of liquidity and one that financial experts use to assess the liquidity risk of a business.
• In comparison to some ratios, it is not a complicated formula to understand. All of the elements of it come from the business’s balance sheet, and so are easy to find.
• Businesses can compare their quick ratio across different time periods. You may be able to spot trends in cash flow that can assist with financial planning.
• The quick ratio is a good metric of cash flow. Knowing how much cash is on hand and that you can cover your bills is an essential part of a successful business.

Disadvantages of the quick ratio

• A disadvantage of the quick ratio is that it only considers current cash stock and not future cash reserves. It only considers your current liabilities and not any long-term debt or liabilities.
• It doesn’t consider the operating cash flow of a business.
• A business that sells large quantities of inventory will have a higher current ratio rather than a quick ratio. One measure doesn’t tell the full story.
• During periods of economic instability or a downturn, businesses could overstate the real liquidity of their marketable securities.

Understanding your quick ratio

A quick ratio above 1 generally indicates that your business has the ability to pay its debts.

If your business has a high quick ratio, it can look more attractive to investors and can sometimes get better interest rates from lenders.

If your business has a quick ratio below 1, you may need to consider your current assets, assess the risk, and decide if you have enough liquid assets. If not, you need to plan and prepare for a worst-case business scenario.