Quick Ratio

Fundamentals · Jul 25, 2019

The Quick Ratio is one of the most basic liquidity ratios used in the company’s analysis.

Some accountants call it the acid-test ratio or the working capital ratio.

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The Quick Ratio is easy to calculate and it has some advantages over similar ratios like the current ratio.

What is the Quick Ratio?

This ratio shows a correlation between the company’s most liquid assets and its current liabilities (mostly soon to be paid debts), therefore it is very useful for the current financial stability analysis.

The Quick Ratio may give you an idea about the firm’s ability to survive certain misfortunes caused by internal or external factors. This ratio gives us a hint on how easy it is for a company to sell its assets to cover current debts if it becomes necessary. This ratio comes especially handy in small and mid-size company analysis as well as for analyzing the balance sheets of the companies which operate in risky business sectors.

How to Calculate the Quick Ratio?

The formula for the quick ratio is quite straightforward:

$$ QR = \frac{LA}{CL} $$

Where:

  • QR: Quick Ratio
  • LA: Liquid Assets
  • CL: Current Liabilities

Those values can be found in a company’s balance sheet.

Liquid Assets is part of the current assets, they include:

  • Cash and cash equivalents
  • Marketable securities (short-term liquid investments)
  • Accounts receivable (almost in all cases and industries, with some exceptions)

Liquid assets don’t include inventory, although it’s a part of current assets.

Current Liabilities are all liabilities that are expected to be settled in one fiscal year: accounts payable, bank account overdrafts, current portion of long-term debt, dividend payable, accrued income taxes or current tax payable, current lease payable etc.

Let’s look at the example of how to calculate the quick ratio. Imagine that a small company has $1,000,000 in cash, $250,000 in liquid market securities and $750,000 in accounts receivable. Also let’s assume that this company has $1,500,000 accounts payable, which would be its current liabilities.

With those numbers to figure out the quick ratio we would need to just add up all assets (1 + 0.25 + 0.75 = 2 mil.) and divide it by the current liabilities, which are 1.5 million. We’d get 1.33, which is equal to 133%.

This tells us that the company in our example has 33% more liquid assets than it has short-term financial obligations, therefore its current financial state is stable, it can cover all its debts immediately if required.

Understanding the Quick Ratio

The main advantage of this indicator is its simplicity, it gives you a fast and easy way to assess the short-term financial stability of any company and to see if such a company can survive in case of a force majeure.

This ratio is helpful for certain kinds of businesses and in various states of the company’s development, but it’s particularly useful for retail business analysis because it has a lot of inventory which is not liquid (it can’t be converted to money easily).

The fact that the quick ratio does not take inventory into account is important for stores, some logistic and trade companies because selling its inventory when it is not supposed to be sold means losing a lot of money. Those companies are based on a small return from the turnover of inventory, so with this ratio, we can see if they have enough resources to survive without selling it.

Usually, the quick ratio of 1 and higher is considered to be OK and normal, but in some cases, depending on the industry, this might not be true and a “healthy” threshold might be lower.

Generally, if a company can cover 100% of its short-term liabilities, this company is in good shape for now.

Examples of the Quick Ratio

Let’s take a quick look at some companies and their quick ratios according to macrotrends.net:

  • Google (Alphabet): 3.93
  • Walmart: 0.21
  • Coca-Cola: 0.71
  • Costco: 0.48
  • Ford Motor: 1.1

It is interesting that many IT companies don’t have quick ratio published or their values are very high, this occurs because liquid assets are a huge portion of their total assets, they don’t have much inventory, they have a large positive cash flow and almost no long-term liabilities. If a company has little or no debt at all quick ratio is meaningless to calculate.

As you can see in retail some major American corporations keep this ratio at quite dangerous levels, but because those companies are large and trusted, they can afford to do so. Many banks also don’t publish quick ratios because it doesn’t make much sense for them due to the nature of their business model, of course, they have huge current liabilities: that is how they operate and it’s close to impossible to have this ratio around 1 for them, because they have to invest the money they receive from clients.

There are plenty of other indicators that are more suitable for assessing banks so the Quick Ratio is not a universal indicator and you should always think if it makes sense to apply it to a certain company or sector.

Lastly, it is worth to mention that sometimes the quick ratio of a company is very close to the current ratio. It happens if this company has almost no inventory, which is often the case with IT companies.

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