What Is Quick Ratio Formula?
The quick ratio Formula is referred to as an enterprise’s capability to cater to its short-term liabilities by converting its nearly available possessions or assets. To mention, it illustrates the company’s ability to settle its immediate liabilities by changing its assets into solid money. Quick Ratio is at times termed acid-test Ratio or Liquid Test ratio.
Quick Ratio intends to weigh an investment’s comfortability to settle its liabilities, excluding the need to sell out inventories or instead get some top-up finances. The greater the Quick Ratio, the more the company is stable financially and the more it’s able to sort out its debts when a crisis arises in the future. A lesser the Quick Ratio which is also known as Acid Test Ratio depicts that the enterprise would struggle in settling its liabilities.
Quick Ratio includes everything owned by a company to cater to its debts by converting them into fast cash. A good Quick ratio or Acid Test Ratio should be 1:1, which implies that a company can sort out its obligations by selling its liquid assets. Quick Ratio helps a company to understand how prepared it is to settle its debts. Also it is part of the Current Ratio Formula.
Why Is It Called “Quick” Ratio?
It is called the “quick” because it only regards the company’s liquid assets that are available to pay the short-term debts. Liquid assets are the assets that a company can turn to cash within a short period of time. The money helps the company pay its bills.
Assets are termed to be more liquid because they are available to the company when needed. There are also marketable securities that a company can sell at a short notice through brokers.
What Are Current Liabilities And Liquid Assets As Used In Quick Ratio Formula?
Liquid assets can be defined as the instantly available belongings owned by a company and quickly changed into money with less effort though mainly selling. It comprises inventories, securities, prepaid expenses, account receivable, and cash equivalents.
On the other hand, current liabilities are investment debts that are yet to be settled to the debtors within a span of a year. To mention; long-term loans, taxes, salaries, and insurance. Liabilities include; Accounts to be paid to, debts that are short term (due by 12 months), and accrued liabilities.
Quick Ratio, in a nutshell, depicts the Ratio between the liquid assets and the current liabilities.
What Is The Impact Of Customer Payment On The Quick Ratio?
All accounts receivable count for the total amount of money a business has as it helps increase the quick Ratio. If the customer payments delay due to unavoidable circumstances, the company will not have enough money to meet its liabilities. Such short-term liabilities include the essential expenses in the business. Lowering the quick Ratio puts the company’s business at Risk.
It may run out of money or the cash available. The company can negotiate an immediate receipt of payments from its customers as this helps the company secure long-term loan payment methods from the suppliers. Conversion of accounts receivable to cash helps the company improve a healthy quick ratio.
Uses of a Quick Ratio
- It acts as a tool for identifying a company’s financial state by financial analysts.
- It’s a show of a company’s short-term liquidity position.
- It weighs a company’s position and its ability to cater for its liabilities in the near future
- It acts to convince the bank payment when the need for a loan application arises in the near future with less need to sell its inventories.
- It is a good tool for comparison and is considered an excellent conservative measure.
- It is an accurate, authentic picture of a company’s working state by serving the importance of being an excellent analytical tool.
- It acts as an eye-opener to the stakeholders. When they notice a Quick high ratio, i.e., which implies that there are too many unique assets, the company may opt to sell them and generate more profits.
- It can also be used as a reference tool when stored for the future. The company can use the previous quick Ratio to weigh out its progress with its current Quick Ratio and plan the way forward.
- It is a good form of managerial skills and competency.
How to Calculate Quick Ratio?
For the quick Ratio calculation, there are specific steps that you should follow to achieve a perfect one. Such steps are explained as follows:
· Make a Balance Sheet
Preparing a balance sheet is vital as a first step. A standard balance sheet is encouraged and not a summary balance sheet. A standard balance sheet is more detailed than a summary balance sheet as it provides both current assets and liabilities and not just totals.
· Obtain the Total Current Assets
It includes the current cash owned by the company, account receivables, the funds that are UN deposited. Inventories are excluded.
· Obtain the Total Current Liabilities
It includes the account to be paid, tax to be paid, and payroll. On-term liabilities are avoided.
· Calculate the Quick Ratio
Using the figures obtained in the above steps, obtain the quick Ratio.
How to Interpret the Quick Ratio
A high Quick Ratio also known as Acid Test Ratio implies that a company can cater to its debts in times of extreme needs. A low quick ratio suggests that the companies’ financial status is not healthy. In times of need, it may struggle to sustain itself. A quick Ratio of 1:1 is compliment able and satisfactory. This is because the liabilities can meet the current assets.
1:1 quick Ratio is not satisfactory if the debtors do not pay since the money is needed hastily to meet the need at hand. A less quick ratio does not imply a bad financial position because inventories are not yet catered in the Quick Ratio. A company with a lower Quick Ratio may get a great financial position if it comprises fast inventories.
Quick Ratio measures a company’s financial stability and pays for the current liabilities by its assets. It complements the current Ratio.
A Quick Ratio of 5:1 is not that much commendable. This is because it shows that a company has five times unused current assets which could instead be sold and used to make extra earnings which makes more profits. Therefore, a more excellent quick ratio shows that a company cannot manage its finance comprehensively.
How Can A Company Improve Its Quick Ratio?
As mentioned earlier, Quick Ratio is a valuable tool in any organization. It is essential to all loaners, capitalists, creditors, banks, and financial analysts. An investment, therefore, has to work hand in hand with all these stakeholders in improving their Quick Ratio also known as Acid Test Ratio. It is somewhat better to keep a quick ratio controlled as earlier as possible, even with lesser liabilities.
- The essential way of improving a company’s Quick Ratio is by settling down all its bills by paying them. This brings forth a better Quick Ratio. It is achieved by paying off the long-term loans and creditors. Current liabilities are indirectly proportional to the Quick Ratio.
- Increasing a company’s output sales also increases its Quick Ratio since it increases the money at hand owned by the company. It is turning inventories into money and money and debtors. Cash owned by the company would outwardly increase hence giving a better Quick ratio.
- Doing away with unproductive assets. All the unproductive assets owned by a company could be sold, increasing the cash owned by an investment as it improves the quick Ratio.
- Sweep accounts. The sweep accounts are the accounts that give interest to the cash deposited for savings in an account. Money that is not in use in the company can be deposited in such accounts, which would later increase the interest causing an increase in the Quick Ratio. When the money is urgently required, the company can transfer it back into a working account.
- Improving the payment period of money ought to be paid to the company. Depreciating the collection period of money ought to be paid to the bank influences the Quick Ratio? Lowering the collection period implies that there will be a quicker cash overflow in the company. The outrageous Risk of unfaithful debtors and long-term debtors is avoided. Terms of payment should be drawn clearly from the start.
Method of Calculating Quick Ratio
There are two main ways used in the calculation of quick Ratio as discussed below:
- Quick ratio= (the current assets – inventories – prepaid) / current liabilities.
The first method emphasizes that a company cannot turn them into cash within a certain period. For example, the company can sell the inventories to receive cash, but it may take time, even more than three months. In the cases where a company sells quickly, it must offer high discount percentages for the goods to be sold. The prepaid items include the insurances. They take a lot of time.
- Quick ratio = (cash + cash equivalents +marketable securities+ accounts receivable) / current
The method is equivalent to the one above, but a slight difference occurs: this concentrates on items that can be sold within a short period and converted to cash.
The Sum of the liquid assets obtains · Quick Ratio or Acid Test Ratio , cash equivalents, and account Owning’s together. It was then dividing obtained by the current liabilities.
- Quick Ratio = sum cash equivalents + liquid assets +Account owning
The Sum of cash equivalents is the readily available assets owned by a company, for instance, savings and investments.
Liquid assets can be market securities. They are financial items that a company can change into money, for instance, current stock.
Account Owings is also referred to as account receivables. It is the cash owed to the investment by debtors.
Quick Ratio Formula Example
Mike’s electronic store is making a requisition for a loan to renovate the storefront. The bank seeks that Mike should provide a detailed balance sheet so that it can be calculated it’s quick
Cash $ 50,000
Stock investments $ 5,000
Prepaid taxes $ 800
Account receivables $ 5,000
Current liabilities $ 20,000
The bank after that compute’s mikes Quick Ratio
QR= Sum of cash equivalents + Liquid assets + Account owning
QR = $ 50,000 + $ 5,000 + $ 5,000
QR = $ 60,000
QR = 3:1
Assuming that Mike lacked a detailed balance sheet that He only provided a summary balance sheet which included;
Prepaid taxes $ 1000
Inventory $ 12,000
Total current assets $ 40,000
Current liabilities $ 6,000
The Quick Ratio can be computed like this;
QR = Total current Assets – Inventory –Prepaid taxes
QR = $ 40,000 – ($ 12,000 + $ 10,000)
QR = $ 18,000
QR = 3:1
Quick Ratio Formula Interpretation
In the interpretation of the quick Ratio, the answer will depend on different factors as discussed below:
- The industry: quick ratios vary from one industry to another. In some industries have steady cash flows compared to one another. In such a situation, a lower ratio is likely.
- In a seasonal industry, a high quick Ratio is expected to cushion against the shortfalls.
- Risk: some business owners fear taking risks. The high the Risk, the higher the Ratio. Those companies fearing taking Risk are likely to tolerate lower quick ratios. Some risks might make a company receive a cash crunch, therefore, increasing the quick Ratio.
- Growth: a quickly growing company requires a higher quick ratio to pay for all its investments. If a company is declining, it is likely to settle for a lower quick ratio. If a company is growing faster, it requires a high quick ratio.
- Economic conditions: if a company is in a state of economic turmoil/uncertainty, it is advisable to increase the quick Ratio to handle unseen shocks. Suppose the company is in a certainty state. It should lower the quick Ratio.
- Inventories: a company may have specific inventories that are easily turned to cash without significant discounts. In such states, the current assets and liabilities may indicate the liquidity of the company. This increases the quick Ratio.
- Accounts receivable: if you encounter difficulties while collecting your accounts receivable, you are advised to increase the Quick Ratio. If you have short and predictable accounts receivable cycle, you need to lower your Ratio.
As seen above, Mike’s Quick Ratio is 3:1. This implies that Mike can pay all of his current liabilities by using his assets and remain with some assets. The quick Ratio gotten 3:1 depicts too many assets that are of no importance and could be converted into liquid cash more efficiently, making more profits in Mike’s electronic shop. This shows that the store has more current assets to overlook its current liabilities.
Mike’s electronic store has $ 3 of current assets to cater for each $1 off its current liabilities. The creditors will hence favor the store because of its Quick Ratio image. This implies that Mike’s electronic store would be much more eligible for the loan issue.
An ideal Quick Ratio depends on the industry a company is operating in. For instance, an investment running in an industry with a quick operating cycle does not need a more excellent Quick Ratio.
Quick Ratio vs. Current Ratio
How Do We Distinguish Quick Ratio From Current Ratio?
Quick Ratio formula makes us of liquid assets, which refers to assets that can be changed into money, divided by liabilities. It does not make use of inventories and prepaid utilities in its calculations.
The current Ratio Formula is calculated by dividing current assets by current liabilities; it includes every type of asset. It makes us of inventories. Inventories are the worth of items owned and stored by the investment to release them for sale to clients. Inventories are slowly processed and unable to be changed to immediate money.
Current Ratio weights the capability of investment to pay its debts in one year. It illustrates how maximally the company can use the available current assets to settle the current liabilities to the analysts and investors.
Current Ratio and Quick Ratio both Re termed to be liquidity ratios. Both measure the business’s credibility to settle its debts optimally. The current Ratio makes use of every current asset in its Sum, whereas the Quick Ratio makes use of quick assets or current assets in its Sum.
Quick Ratio makes use of the assets that the company can easily change into money. The current Ratio makes use of inventories which is a part of an asset. Inventories are not able to be changed into money quickly in a span of 90 days.
Below are some of the differences between Quick Ratio Formula and Current Ratio Formula;
- In Currently ratio, the available assets can be changed into money within a year while in the quick ratio, the Currently available assets can be changed into money within 90 days or even lesser.
- The current ratio makes use of an inventory in its current assets while the quick ratio does not make use of an inventory in its current assets
- In current ratio, the most convenient ratio is 2:1 while in the quick ratio, the most convenient Quick Ratio is 1:1
Merits of Current Ratio Formula
- It is an accurate picture of how a company is financially
- It also gives a hint on how a company operating
- The current ratio also displays the management competency.
Demerits of Quick Ratio Formula
- The current Ratio may not be adequate to analyses
- Inclusion of inventories can lead to an overstatement of the Current Ratio
- There may be an unstable ratio during periods of seasonal sales.
- There is variability’s in liquid assets and liabilities may alter the Current Ratio
Merits of Acid Test Ratio
- It gets rid of inventories from calculations.
- Some of the vital information such as Cash inputs and bank Overdrafts
- The need for evaluating inventories is unnecessary
- It gives relevant information about the company, which the company uses for its benefits.
Demits Of Acid Test Ratio
- It puts away the stage and timing of cash input.
- It is not a good indication for investment models to indicate short-term problems.
- Unfavorable when Acid Ratio is centered on dependent Ratio.
Current Ratio Formula
Current Ratio = Current Assets (Inclusive of inventory)
Example of Quick Ratio Formula;
If an investment has;
- Cash $ 70,000
- Inventory $ 50,000
- Short-Term debts $ 30,000
- Account Payables $ 30,000
- Market securities $ 20,000
Cash assets is gotten by adding cash + Accounts payable + Inventory
Cash assets = $70,000 + $ 30,000 + $ 50,000
Cash assets = $ 150,000
Cash liabilities are gotten by the Sum of Short term debts and Market insecurities.
Cash liabilities = Short term debts + Market insecurities
Cash liabilities = $ 30,000 + $ 20,000
Cash liabilities = $ 50,000
Current Ratio = $ 150,000
Current Ratio = 3: 1
The investment has a Current Ratio of 3: 1. This Ratio shows that it can comfortably settle its loans and debts. A Current Ratio of more than one shows how well a company is financially stable. A significantly greater current ratio shows that a company is an excess money not used instead of putting it down as an investment in their business.
Uses of a Current Ratio Formula
The Current Ratio Formula, as mention, plays a vital role similar to the Quick Ratio.
- It weighs out the companies capacity to cater for its short-term liabilities, e.g., loans those due to a span of a year.
- It is an excellent analytical tool for viewing a company’s stand financially.
- By also covering the inventories, it caters to all sectors involved in the company as seen in the prepared standard balance sheet, ensuring that no area is left.
To sum it up, as discussed above Quick Ratio Formula, it is vividly clear that both the Quick Ratio and the Current Ratio play a pretty important part in any company’s success. They give a visual view of the financial progress of the company by acting as a gauge.
The Quick Ratio Formula and the Current Ratio Formula both act as essential detrimental analytical tools for a business organization.
My Name is Nadeem Shaikh the founder of nadeemacademy.com. I am a Qualified Chartered Accountant, B. com and M.Com. having professional and specialize experience in field of Account, Finance, and Taxation. Total experience of 20 years in providing businesses solution in Taxation, Accounting, and Finance with all statutory compliance with timely business performance Financials reports. You can contact me on email@example.com or firstname.lastname@example.org.