Liquidity Measurement Ratios: Quick Ratio

The quick ratio, also known as the acid-test ratio, is a liquidity ratio that further refines the current ratio by measuring the level of the most liquid current assets available to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which generally are more difficult to turn into cash. A higher quick ratio means a more liquid current position.

The formula for calculating a company’s quick ratio is:

• (Cash equivalents + marketable securities + accounts receivables) divided by current liabilities

Conservative version of current ratio

By focusing on the current assets that are generally the easiest to convert to cash, the quick ratio is conceivably a better barometer of the coverage provided by these assets for the company’s current liabilities should company experience financial difficulties.

Inventory is generally considered to be less liquid than these other current assets.

A rule of thumb is that a quick ratio greater than 1.0 means that a company is sufficiently able to meet its short-term obligations.

What it tells us

A low and/or decreasing quick ratio might be delivering several messages about a company. It could be telling us that the company’s balance sheet is over-leveraged. Or it could be saying the company’s sales are decreasing, the company is having a hard time collecting its account receivables or perhaps the company is paying its bills too quickly.

A company with a high and/or increasing quick ratio is likely experiencing revenue growth, collecting its accounts receivable and turning them into cash quickly and likely turning over its inventories quickly.

Factors unique to different companies and industries will also impact a company’s quick ratio, such as the timing of capital expenditures and other asset purchases, allowances for bad debt and other financial policies. When looking to use the quick ratio to compare companies, the most valid comparison is generally between companies in the same industry.

Not a perfect indicator

The elimination of inventories makes the quick ratio a somewhat better barometer of a company’s ability to meet its short-term obligations than the current ratio. But like the current ratio, the acid-test ratio is still not a perfect gauge. It is not realistic to assume that a company will liquidate all current assets that comprise the quick ratio to cover short-term debts since the company still needs a level of working capital to remain a going concern.