The Quick Ratio (also referred to as the acid test ratio) is a financial ratio formula whose main aim is to help the companies measure their ability to pay off their short-term liability dues within the next 90 days with the help of their near-cash assets. It tries to portray how a firm can maximise its Quick Assets to settle short-term debts towards its creditors. Management can use this ratio to get an idea about their preparedness to pay off immediate loan obligations. It can also use this ratio to find out methods to increase its cash and near-cash assets. The ratio is arrived at by dividing the value of the Quick Assets of an organisation by the value of its Current Liabilities. The formula to calculate the Quick Ratio is as mentioned below:
Quick Ratio = Quick Assets/Current Liabilities
Quick Assets are the assets present in a company’s balance sheet that are convertible into cash at short notice. They include cash and cash equivalents, accounts receivable and marketable securities. Current Liabilities, on the other hand, are short-term obligations that a firm needs to pay off to the creditors within a year’s time. Some of the Current Liabilities that are present in the balance sheet include short-term debt, accounts payable, outstanding income taxes, dividends payable and accrued expenses.
Advantages of Quick Ratio
Companies have been using the Quick Ratio to measure their capability of disposing of immediate debt obligations using cash and near-cash assets. There are a number of advantages of using the Quick Ratio for an organisation, which we will discuss in the below paragraphs:
- The main advantage for a company of using the Quick Ratio is that it can easily help them to adequately gauge its overall financial health. If the Quick Ratio is less than one, it denotes that the firm has to shore up its cash and near-cash assets to cover the near-term debt obligations or else it will end up facing liquidity problems. However, if the Quick Ratio is more than 1, the company is doing pretty well in terms of handling its short-term liabilities. Companies should aim for this number as it will help them to have enough reserves at all times.
- The Quick Ratio will also help a firm get an idea of the efficiency of its overall operating cycle. It will bring about an understanding of the areas where they need to change drastically to avoid any sort of debt. It is important to know that because in case the Quick Ratio ends up being lower than 1, the management will have to address this problem immediately before it becomes too big to handle.
- Calculating the Quick Ratio also informs the decision-makers in a firm if they are able to maintain an optimal level of Quick Assets to help pay off their immediate liabilities. Companies must focus on having a Quick Ratio of more than one. It is important because having enough cash and near-cash assets can help them cover the liabilities without much trouble.
Limitations of Quick Ratio
The Quick Ratio is useful in a number of ways, but not all firms prefer to use it as the only means to measure their liquidity. There are several issues with this financial ratio, which are as follows:
- The Quick Ratio is not a foolproof indicator of the real liquidity position of a firm. It would not be advisable for any management to rely solely on this financial ratio. The main issue with the Quick Ratio is that it gives no information about things like working capital that can help them to make an assessment of the firm’s true financial position.
- The method of calculating the acid test ratio does not include inventory because it is not a part of the Quick Assets. Although inventory is assumed to take more time for conversion into cash, there are several firms where it is very easy to sell it off at a marketable price. So if the management relies solely on the Quick Ratio, they may end up underestimating the capability of their firm to pay off its immediate-term debt obligations.
- Another demerit of using the acid test ratio is that it tends to ignore the timings and level of the cash flows that take place within a company. This sometimes leads to an incorrect estimation of a firm’s ability to pay off its creditors on time and can cause problems for the business in the future.
The Quick Ratio is, without doubt, an important measure to evaluate the ability of a firm to clear off its short-term liabilities. It is essential to help companies assess their liquidity. Companies should be advised to not solely rely on just one financial ratio but also use other measures to ascertain their financial position. This way, they will have a better idea about the liquidity position of their business.
- Difference Between Capital Expenditure and Revenue Expenditure
- Balance Sheet Vs Consolidated Balance Sheet
- Adjustment for Accumulated Profits and Losses
- Balance of Payments Surplus and Deficit
Frequently Asked Questions
What does a Quick Ratio of 5 mean for a company?
A Quick Ratio of 5 means that a company’s Quick Assets are five times the size of its Current Liabilities. It also means that the company is well equipped in terms of liquidity to cover its immediate obligations to creditors.
If the Quick Assets of a small firm is Rs. 8000 and the Current Liabilities is Rs. 8000, what would be the Quick Ratio for that firm? What does it say about the liquidity of the firm?
To calculate the Quick Ratio, we use the below formula:
Quick Ratio = Quick Assets/Current Liabilities
So if Quick Assets is Rs. 8000 and Quick Liabilities are Rs. 8000, then the Quick Ratio will be 1 (80000/80000).
A Quick Ratio of 1 is adequate for the company because it signifies that they have enough cash and near-cash assets to cover the immediate-term obligations towards its creditors.