The quick ratio is like a financial health check-up for businesses, big or small. This financial ratio zeroes in on the most liquid assets—those that can be turned into cash quickly and compares them to short-term liabilities. Think of it as a snapshot of how well your business can handle unexpected expenses or opportunities.
With the focus on what you can turn into cash fast, the quick ratio gives you a conservative and clear picture of your company’s ability to meet immediate financial demands. Whether you’re running a local shop or a large company, keeping an eye on this ratio is important.
What is the Quick Ratio?
The quick ratio is a vital tool that helps businesses understand their short-term liquidity position. In simple terms, it’s a measure that tells you how well your company can cover its current liabilities with its quick assets. Quick assets include things like cash, marketable securities, and accounts receivable, which can be easily converted into cash.
Unlike the current ratio, which includes all current assets, the quick ratio focuses only on those assets that can be quickly turned into cash. This makes it the true acid test of your company’s ability to pay off its short-term obligations. If you want to know how well your business can meet its immediate financial demands, the quick ratio is a key indicator to look at.
Why Should Business Owners Care About the Quick Ratio?
In times of crisis, understanding how quickly assets can be turned into cash is super important. It’s all about cash flow, and the quick ratio helps you see how well your business can handle unexpected financial bumps.
But that’s not all. A healthy quick ratio (over 1) can lead to favorable interest rates when borrowing money, making it more cost-effective to grow your business.
The good quick ratio also makes your company more attractive to investors, as it shows financial stability and efficient management of assets.
So what to do if your quick ration is below 1? Consider strategies like reducing unnecessary inventory or focusing on collecting receivables more quickly. These actions can enhance your company’s financial position and give you more flexibility and confidence in your business decisions.
The Quick Ratio Formula
The quick ratio is calculated by dividing the quick assets (cash, marketable securities, and accounts receivables) by the current liabilities. It’s expressed as:
Quick Ratio = Quick Assets / Current Liabilities
Let’s look at these components in more detail.
Quick assets are those assets that can be quickly converted into cash. They include:
- Cash: The money available in the business.
- Cash Equivalents: Short-term investments that can be easily turned into cash.
- Marketable Securities: Investments that can be sold quickly.
- Accounts Receivable: Money owed to the business that is expected to be paid soon.
Current liabilities are the obligations that the company will need to pay within the next year. It includes things like short-term loans, accounts payable, and other debts due within a year.
This formula gives you a snapshot of how well your business can meet its short-term obligations using assets that can be quickly converted into cash.
How to Calculate the Quick Ratio
Calculating it is a straightforward process – let’s see the steps.
- Identify Quick Assets: First, you’ll need to summarize the totals for the quick assets.
- Identify Current Liabilities: Next, find the total amount of current liabilities. These are the obligations your company owes and will need to pay within the next year.
- Calculate the Quick Ratio: Finally, divide the total quick assets by the current liabilities -> Quick Ratio =(Cash + Marketable Securities + Account Receivables) / Current Liabilities
Why Isn’t Inventory Included?
While inventory is considered a current asset, it’s not included in the quick ratio calculation. The reason for this exclusion lies in the nature of inventory itself. So you can also calculate the quick ratio by removing the inventory from the current assets:
Here are the characteristics of inventory that prevent it from being part of the Quick Ratio.
Time to Convert into Cash: Inventory may take too long to convert into cash. Depending on the type of goods and market conditions, selling inventory can be a slow process. The quick ratio focuses on the assets that can be converted into cash fast, and inventory doesn’t always meet this expectation.
Uncertainty in Value: The value of inventory can fluctuate, and there may be uncertainties in selling it at the expected price. This makes it a less reliable asset when considering the ability to cover pressing liabilities.
Focus on Liquidity: The quick ratio is designed to be the acid test of a company’s short-term liquidity. By excluding inventory, this ratio offers a more conservative view of how well a business can meet its immediate financial obligations with only the most liquid assets.
So, inventory is left out of the quick ratio calculation because it may not provide the quick access to cash that the ratio aims to measure.
Quick Ratio vs. Current Ratio
We have already discussed how the Quick ratio is calculated.
The current ratio, which is another liquidity metric, is calculated by dividing all current assets (including inventory) by current liabilities.
So the main differences between these two important ratios are:
- The quick ratio focuses on the most liquid assets, excluding inventory, as it may take longer to convert into cash.
- The current ratio includes all current assets, providing a broader view of a company’s liquidity.
Both ratios are essential in assessing your company’s ability to meet short-term obligations. The quick ratio offers a more conservative view, focusing on assets that can be quickly converted into cash.
The current ratio provides a more comprehensive perspective, including all assets expected to be converted into cash within a year.
Small business owners can use both ratios to understand their financial stability and make informed decisions. On the other side, lenders often look at these ratios to assess the creditworthiness of a business.
Why is the Quick Ratio Better Than the Current Ratio?
There are several reasons of why business owners prefer tracking the quick ratio to the current ratio.
First, the quick ratio focuses on short-term, highly liquid assets.
Second, the quick ratio provides a more conservative measure of a company’s ability to cover short-term liabilities.
Third, tn times of financial stress or unexpected expenses, the quick ratio can be a more accurate reflection of a company’s ability to pay.
Fourth, some lenders and financial analysts prefer the quick ratio as it provides a more cautious view of a company’s liquidity.
Let’s take a look at an example that we came up with for demonstrative purposes.
Let’s assume the business in our focus has the following figures in their 2022 balance sheet.
- Current Assets: $75 million
- Quick Assets (Cash, Marketable Securities, Accounts Receivable): $40 million
- Current Liabilities: $55 million
and for 2021:
- Current Assets: $70 million
- Quick Assets: $35 million
- Current Liabilities: $50 million
- 2022 Current Ratio: $75M / $55M = 1.36
- 2022 Quick Ratio: $40M / $55M = 0.73
- 2021 Current Ratio: $70M / $50M= 1.4
- 2021 Quick Ratio: $35M / $50M = 0.7
Analyzing Short-Term Liquidity
The decrease in the current ratio from 1.4 to 1.36 suggests a slight reduction in overall short-term liquidity. What might the causes be? Does the company have more debt to finance because it was investing in growth? Does the company have less payables and more receivables? There should be definitely some context to that.
The increase in the quick ratio from 0.7 to 0.73 indicates an improvement in liquidity, which is great. But many questions arise here too. Has the company introduced more prudent financial measures? Were does the injection of cash come from?
By using the quick ratio alongside the current ratio and doing some analysis, you can build a clear picture about your business’ financial health. See the other important financial ratios to track if you run a business.