Quick Ratio

What is Quick Ratio? 

The quick ratio indicates the short-term liquidity position of a company. It signifies its ability to manage short-term obligations with its liquid assets. It also hints about the ability of the company to instantly utilize its near-cash assets for paying down its current liabilities. 

The ratio is also referred to as the acid test ratio as it is designed to produce instant results. It measures the ability of a business or an individual to meet short-term expenses and current liabilities. The quick ratio does not consider the inventory as it is difficult to convert it into cash and sell.  

Here is the Quick Ratio formula that can be used for estimating the ratio of a company:

Quick Ratio= Cash equivalents+Accounts receivables+Marketable securities / Current liabilities

Key Takeaways:

  • The quick ratio shows the company’s ability to pay its liabilities without having to take a loan or sell its inventory. 
  • A high quick ratio indicates the financial health of the company. The company has better liquidity with a high quick ratio and with a low ratio; it can struggle to pay off its debts.

How to use Quick Ratio?

A high quick ratio indicates greater liquidity for a company. So, what is a good quick ratio? A quick ratio greater than 1.0 indicates that the business is capable of meeting its short-term obligations. A decreasing or low ratio generally hints that the business under consideration has either acquired too much debt or its sales are gradually declining.

The Quick ratio can also indicate that the company is having a hard time collecting its accounts receivable or is paying its bills too quickly. It is also utilized by prospective lenders and creditors to identify whether the company can pay off its debts on time or not.

How to calculate Quick Ratio?

To evaluate Quick Ratio, you need to locate the components of the equation from the company’s balance sheet. You will find the information under the current assets and current liabilities section under a company’s balance sheet. You just need to enter the corresponding values in the equation for performing the calculation.   

The numerator of the liquid assets should include the assets that you can easily convert into cash within a short time such as within 90 days or less without compromising with the price. Inventory is not included in the calculation as the company will have to apply a steep discount for selling its inventory in less than 90 days. 

Quick Ratio Example:

Let us consider an example of two companies ABC Inc. and XYZ Inc. for estimating Quick Ratio.  

Here is the extract from the balance sheet of ABC Inc:

Cash and Cash Equivalents₹21,12,00
Short-term investments₹2,04,810
Deferred income taxes₹55,460
Other current assets₹2,30,330
Total current assets₹8,93,780
Total current liabilities₹8,06,100

Here is the extract from the balance sheet of XYZ Inc:

Prepaid expenses₹11,160
Deferred income taxes₹12,420
Other current assets₹41,480
Total current assets₹5,17,870
Total current liabilities₹4,21,910

Quick Ratio for ABC Inc.= ₹21,12,00 + ₹2,04,810 + ₹1,68,490 / ₹8,06,100 ₹5,84,500 / ₹8,06,100 = 0.725

Quick Ratio for XYZ Inc.= ₹5,17,870 - ₹34,850 - ₹11,160 - ₹12,420 - ₹41,480 / ₹4,21,910 ₹4,17,960 / ₹4,21,910 = 0.99

It is evident from the calculations that XYZ Inc. has a quick ratio of 0.99 and ABC Inc. has a quick ratio of 0.725. While ABC has a safe quick ratio, ABC has better overall liquidity especially in the case of a crunch.

A ratio of 1:1 is considered to be an ideal quick ratio hinting that the business possesses enough assets for immediate liquidation to meet its current liabilities. A ratio of less than 1 indicates that the company cannot pay off its liabilities outstanding in the short term. A ratio greater than 1 indicates that the company retains its liquid assets for discharging its current liabilities in no time.  

Importance of Quick Ratio:

Quick ratio interpretation reveals a wealth of information about the financial condition of a particular business. It assesses the value of various liquid assets present at the disposal of the company against its liabilities. It could be anything including its debts or other obligations that it needs to clear within 12 months. Such obligations can be discharged conveniently with liquid assets that the company holds. 

A quick ratio precisely indicates the ability of a company to discharge its obligations and debts. A healthy liquidity ratio signifies the competence of the organization and assures a stellar business performance. An analyst or investor can use the ratio to identify if a particular company has enough liquid assets for discharging its short-term liabilities.

If we take a look at the ratio from a lender’s perspective, the higher the ratio, the better it is. A higher value indicates that the borrower can make interest and principal payments even if the business has to face reduced revenues and unexpected expenses. Lenders prefer dealing with creditworthy borrowers and reward them with favorable terms and larger loans. The quick ratio and super quick ratio are popular measures of liquidity.  

Super Quick Ratio:

Also referred to as the Cash Ratio or the Liquid Ratio, the Super Quick Ratio is considered when liquidity is restricted to cash and cash equivalents. It is estimated by dividing super quick assets by current liabilities for any business. 

Super Quick ratio analysis is the most stringent test performed for assessing the current liquidity situation for any business. The evaluation strictly includes cash and marketable securities.    

Super Quick Ratio = Super Quick Assets / Current Liabilities (or)

Super Quick Ratio= (Cash + Marketable Securities) / Current Liabilities

In summary:

The quick ratio is an easy figure to estimate provided you have the balance sheet of a company available. You can enter the values into the formula to estimate the Quick ratio in seconds. It is a popular metric for assessing the financial health of the company. While using the ratio to draw comparisons, it is vital to compare ratios of companies within the same industry and not across the industries. This is because certain industries possess longer credit collection cycles thereby impacting the account receivables and other parameters.

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