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Cash fuels company operations, and a lack of it can force a company into bankruptcy. Cash is needed to pay for immediate expenditures, such as salaries and wages, invoices from suppliers, purchase of inventory, and dividends. Lack of cash, or illiquidity, can push a company into insolvency, which is an inability to pay its bills.
What is Quick Ratio?
The quick ratio is a financial indicator of short-term liquidity or the ability to raise cash to pay bills due in the next 90 days. It is defined as: quick assets divided by current liabilities, and it is also known as the acid-test ratio and the quick liquidity ratio:
Quick Ratio = Quick Assets / Current Liabilities
Terms used are:
- Quick assets: The sum of a company’s cash, cash equivalents (i.e., money market accounts, certificates of deposits, savings accounts, Treasury bills that mature within 90 days), marketable securities (publicly traded stocks and bonds, commercial paper), and receivables. It does not include other current assets such as inventory and prepaids (such as prepaid insurance), which can’t be quickly turned into cash.
- Current liabilities: These are obligations that must be paid within one year. They include the interest on long-term debt that must be paid in the next year. Common payables include those for wages, taxes, interest, utilities and insurance.
How to Calculate the Quick Ratio
There are two ways to calculate the quick ratio:
- QR = (Current Assets – Inventories – Prepaids) / Current Liabilities
- QR = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
The first version emphasizes the items that can’t be quickly turned into cash. Inventories can be sold off for cash, but it might take more than 90 days. To attempt to sell them off rapidly, you might have to accept a large discount to their market value. Prepaids expenses are items like prepaid insurance and prepaid subscriptions. Theoretically, you could attempt to cancel them and receive a refund, but it can take a long time and you will probably not receive the full value of the prepaid.
The second version is equivalent to the first, but it concentrates on items that can be quickly turned into cash. Accounts receivable might be problematic to the extent you have accounts that will be delinquent, unpaid or have due dates longer than 90 days. However, in most situations, you should be able to collect the money due you within 90 days unless you have historical evidence to the contrary.
To take an example, the following table shows excerpts from the balance sheet of Company X:
|Assets||In Thousands of Dollars||In Thousands of Dollars|
|Cash on hand||25|
|Cash in bank||15|
|Income tax payable||55|
|Deferred taxes payable||15||45|
Using Equation 1, quick assets equals ($198,000 - $50,000 - $3,000), or $145,000. Using Equation 2, quick assets equal ($25,000 + $15,000 + $30,000 + $75,000), or $145,000. Current liabilities equal $160,000, so the quick ratio is:
Quick Ratio = Quick Assets / Current Liabilities = $145,000 / $160,000 = 0.91
How to Interpret Quick Ratio
In our example, Company X has a quick ratio of 0.91, meaning it has 91 cents available from quick assets to pay every dollar of current liabilities. Is that good or bad? The answer depends on several factors:
- Industry: Average quick ratios can vary considerably from one industry to the next. In an industry where cash flows are steady and predictable, such as retail, a lower ratio can be fine, because anticipated revenues can be counted on to supply needed cash. On the other hand, in a volatile or seasonal industry, a higher quick ratio will cushion the company against shortfalls in revenue.
- Risk: Some business owners don’t mind taking on risk, including the risk that they might face a cash crunch. For them, a lower quick ratio might be tolerable, whereas a risk-averse owner might require a much higher ratio.
- Growth: A rapidly growing company might need a higher ratio to pay for investments and expanded operations. A steady or declining business can settle for a lower ratio.
- Economic conditions: During times of economic turmoil, it’s prudent to increase your quick ratio to handle unforeseen shocks. Placid times are the inverse.
- Inventories: Your company might have a type of inventory that is very easy to quickly liquidate without a significant discount. If so, your current ratio (current assets/current liabilities) might be a better indicator of liquidity. In this case, the current ratio would be higher than the quick ratio but would not necessarily be a problem.
- Accounts receivable: If your accounts receivable is difficult to collect, you will want to raise your quick ratio by putting aside additional cash. If you have a short and predictable accounts receivable cycle, you can probably lower your quick ratio.
- Too high: A quick ratio that is too high means that some of your money is not being put to work. This indicates inefficiency that can cost your company profits. If you don’t have a special need for a high ratio, you will want to lower it to at least the industry average.
Business owners can improve their quick ratios by putting more of their net profits into cash, cash equivalents and marketable securities. They can also reduce their liabilities by cutting expenses and repaying debt. Conversely, if their quick ratio is too high, they can invest some of their extra quick assets into projects that will grow the business or make it more efficient.
From a lender’s point of view, the higher the quick ratio, the better. A higher quick ratio indicates the borrower will be able to make principal and interest payments even if the business runs into unexpected expenses or reduced revenues. Lenders prefer creditworthy borrowers and might reward them with larger loans and/or more favorable terms. The quick ratio is one of three popular measures of liquidity, the other two being the current ratio and the cash ratio.