What is Quick Ratio? How it is different from Current Ratio? Formula, Importance & Example|

Quick Ratio:

The quick ratio, which is also known as the acid-test ratio, is a financial ratio that measures a company’s ability to meet its short-term financial obligations with its most liquid assets. The quick ratio is calculated by dividing a company’s quick assets (such as cash, accounts receivable, and marketable securities) by its current liabilities (short-term debts due within one year).

Unlike the current ratio, which includes all current assets, the quick ratio only considers assets that can be easily converted to cash to pay off immediate liabilities. The quick ratio is a more conservative measure of a company’s liquidity than the current ratio, as it does not include inventory or other less liquid assets that may take longer to convert to cash.

A high quick ratio indicates that a company has enough liquid assets to cover its short-term financial obligations, while a low quick ratio may indicate that a company may struggle to meet its short-term obligations.

Ideal/Good Quick Ratio:

A good quick ratio is typically considered to be 1:1 or higher, which means that a company has enough quick assets to cover its short-term liabilities. However, what is considered a good quick ratio can vary depending on the industry and the company’s specific circumstances.

Generally, a quick ratio of 1:1 or higher indicates that a company is in good financial health and is able to pay off its immediate debts without having to rely on selling inventory or other less liquid assets. This can be important for companies that may experience unexpected cash flow issues or have a high level of short-term debt.

However, it’s important to note that a quick ratio that is too high may indicate that a company is holding too much cash or other liquid assets that could be better invested elsewhere. In some cases, a lower quick ratio may be acceptable if a company has a strong history of managing its cash flow effectively and has other assets that can be easily converted to cash if needed.

Formula & Importance:

Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Here are some important points about the quick ratio:

1. It is a measure of liquidity: The quick ratio is an important measure of a company’s ability to meet its short-term obligations. It shows how much of its current liabilities a company can pay off using its most liquid assets.
2. It excludes inventory: The quick ratio excludes inventory from current assets because inventory is often not as easily convertible to cash as other current assets. This makes the quick ratio a more conservative measure of liquidity than the current ratio, which includes inventory.
3. A higher quick ratio is better: A higher quick ratio indicates that a company has a greater ability to meet its short-term obligations with its most liquid assets. A quick ratio of 1 or higher is generally considered good, although the ideal quick ratio may vary depending on the industry and the company’s specific circumstances.
4. It is not a comprehensive measure of financial health: While the quick ratio is an important measure of liquidity, it does not provide a comprehensive view of a company’s financial health. Other metrics, such as profitability and debt levels, are also important to consider when evaluating a company’s financial health.

How Quick Ratio is different from Current Ratio:

Quick Ratio and Current Ratio are both financial ratios that are used to measure a company’s ability to meet its short-term obligations. However, they are calculated using different components and provide slightly different information about a company’s liquidity.

The Quick Ratio, also known as the Acid-Test Ratio, measures a company’s ability to pay off its short-term liabilities with its most liquid assets, such as cash, marketable securities, and accounts receivable. It excludes inventory from the calculation, as inventory may take longer to convert into cash. The formula for Quick Ratio is:

Quick Ratio = (Current Assets – Inventory) / Current Liabilities

The Current Ratio, on the other hand, measures a company’s ability to pay off its short-term liabilities with its current assets, including cash, marketable securities, accounts receivable, and inventory. It includes inventory in the calculation, as inventory is considered a current asset. The formula for Current Ratio is:

Current Ratio = Current Assets / Current Liabilities

Summary – Quick Ratio provides a more conservative measure of a company’s ability to meet its short-term obligations, as it only includes the most liquid assets, while the Current Ratio provides a broader view of a company’s liquidity by including all current assets.

Example, how to calculate the quick ratio:

Let’s say a company has current assets of $100,000, which includes $20,000 in cash, $30,000 in accounts receivable, and $50,000 in inventory. Its current liabilities are $60,000.

Quick ratio = (Current assets – Inventory) / Current liabilities Quick ratio = ($100,000 – $50,000) / $60,000 Quick ratio = $50,000 / $60,000 Quick ratio = 0.83

In this example, the quick ratio is 0.83, which means the company has $0.83 in quick assets (cash and accounts receivable) to cover every $1 of current liabilities. A higher quick ratio is generally considered better, as it indicates a company is more capable of meeting its short-term obligations.

For any query feel free to connect with us via your valuable comments and email – moneysmint99@gmail.com.