Quick Ratio Definition Interpretation Analysis

Quick Ratio Definition

Due to the prohibition of inventory from the formula, this ratio is a better sign than the current ratio of the ability of a company to pay its instant obligations. It is also known as the acid test ratio or liquid ratio.

Quick Ratio Formula = Quick Assets / Quick Liabilities. = (Cash and Cash EquivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more + Accounts Receivables) / (Current liabilities – Bank Overdraft)

A ratio of 1: 1 indicates a highly solvent position. This ratio serves as a supplement to the current ratio in analyzing liquidity.

P&G’s current ratio was healthy at 1.098x in 2016. However, its quick ratio is 0.576x. It implies that many of P&G’s current assets are stuck in lesser liquid assets like inventory or prepaid expenses.

The Importance of Quick ratio

This ratio is one of the major tools for decision-making. It previews the ability of the company to make a settlement of its quick liabilities in a very short notice period.

Interpretation Quick Ratio

It is a sign of an organization’s solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more and should be analyzed over time and in the industry’s circumstances the company controls in.Companies should focus on keeping this ratio that maintains adequate leverage against liquidity riskLiquidity RiskLiquidity risk refers to ‘Cash Crunch’ for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.read more, given the variables in a particular business sector, among other considerations.The more uncertain the business environment, the more likely companies would keep higher quick ratios. Reversely, where cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more are constant and foreseeable, companies would call on to maintain the quick ratio at relatively lower levels. Companies must attain the correct balance between liquidity risk caused by a low ratio and the risk of loss caused due to a high ratio.An acid ratio higher than the industry average may be advised that the company is investing too many resources in the business working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It’s a measure of a company’s liquidity, efficiency, and financial health, and it’s calculated using a simple formula: “current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)“read more, which may more profitably be used elsewhere.If a company has extra supplementary cash, it may consider investing the excess funds in new ventures. On the other hand, if the company is out of investment choices, it may be advisable to return the surplus funds to shareholders in hiked dividend payments.The acid test ratio, which is lower than the industry average, may suggest that the company is taking a high risk by not maintaining a proper shield of liquid resources. Otherwise, a company may have a lower ratio due to better credit termsCredit TermsCredit Terms are the payment terms and conditions established by the lending party in exchange for the credit benefit. Examples include credit extended by suppliers to buyers of products with terms such as 3/15, net 60, which essentially implies that although the amount is due in 60 days, the customer can avail a 3% discount if they pay within 15 days.read more with suppliers than its competitors.While interpreting and analyzing the acid ratio over various periods, it is necessary to take into account seasonal changes in some industries, which may produce the ratio to be traditionally higher or lower at certain times of the year as seasonal businesses experience illegitimate effusion of activities leading to changing levels current assets and liabilities over the time.

Analysis of Quick Ratio

The following illustrates the calculation and interpretation of the quick ratio provided.

Example 1

The following is the information extracted from audited records at a large industrial company. (Amount in $)

Assume that Current Assets = Cash and Cash Equivalents + Accounts ReceivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more + Inventory. There are no other items included in current assets.

You must calculate the quick ratio and analyze the ratio trend to judge the company’s short-term liquidity and solvency.

Calculation of the quick ratio of the company for the following years:

(Amount in $)

From the above-calculated data, we analyzed that the quick ratio has fallen from 1.7 in 2011 to 0.6 in 2015. It must mean that most the current assetsThe Current AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more are locked up in stocks over time. The ideal standard quick ratio is 1: 1, which means that the company is not in a position to meet its immediate current liabilities; it may lead to technical solvency. Hence, one should take steps to reduce the investment in the inventory and see that the ratio is above level 1: 1.

The ideal standard ratio is 1: 1. However, the company is not in a position to meet its immediate current liabilities; it may lead to technical solvency. Hence, one should take steps to reduce the investment in the inventory and see that the ratio is above level 1: 1.

Example 2

XYZ Ltd. provides you with the following information for the year ending 31st March 2015: –

Working Capital = $45,000Current ratio = 2.5 Inventory = $40,000

You are required to calculate and interpret a quick ratio.

Calculation of current assets and current liabilities

Working capital = $45,000

Current ratio = 2.5

= Current assets / Current liabilities = 2.5 = Current assets = 2.5 * Current Liabilities

So, working capital = Current Assets – Current Liabilities

= 45,000

= 2.5 Current Liabilities – current liabilities

= 1.5 * current liabilities = 45,000

Current liabilities = 45,000 / 1.5 = 30,000

Therefore, current assets = 2.5 * current liabilities = 2.5 * 30,000 = 75,000

So, current assets and liabilities are $75,000 and $30,000, respectively.

Calculation of acid test ratio

Given Inventory = $40,000

Current assets = $75,000

So, Quick assets = Current assets – Inventory = $75,000 – $40,000 = $35,000

As no bank overdraft is available, current liabilities will be considered quick liabilities.

So, the quick liabilities = $30,000

Therefore,

Ratio = Quick assets / Quick liabilities

Ratio = $35,000 / $30,000

Ratio = 1.167

As the calculated acid test ratioCalculated Acid Test RatioAcid test ratio is a measure of short term liquidity of the firm and is calculated by dividing the summation of the most liquid assets like cash, cash equivalents, marketable securities or short-term investments, and current accounts receivables by the total current liabilities. The ratio is also known as a Quick Ratio.read more is 1.167, which is more than the ideal ratio of 1, the company can better meet its obligation through quick assets.

Colgate Example

Let us now look at the calculations in Colgate.

The ratio of Colgate is relatively healthy (between 0.56x – 0.73x). In addition, this acid test shows us the company’s ability to pay off short-term liabilities using receivables and cash & cash equivalents.

Below is a quick comparison of the Colgate vs. P&G vs. Unilever ratio.

source: ycharts

As compared to its peers, Colgate has a very healthy ratio.

While Unilever’s quick ratio has been declining for the past 5-6 years, we also note that the P&G ratio is much lower than Colgate’s.

Microsoft Example

As pointed out from the below graph, the cash ratioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.read more of Microsoft is a low 0.110x. However, its quick ratio is a massive 2.216x.

source: ycharts

Microsoft’s quick ratio is pretty high, primarily due to around $106,730 billion in short-term investments!Short Term InvestmentsShort term investments are those financial instruments which can be easily converted into cash in the next three to twelve months and are classified as current assets on the balance sheet. Most companies opt for such investments and park excess cash due to liquidity and solvency reasons.read more So that puts Microsoft in a very comfortable position from the point of view of liquidity/solvency.

source: Microsoft SEC Filings

Quick Ratio Video

Conclusion

We note that current assets may contain a large inventory, and prepaid expensesPrepaid ExpensesPrepaid expenses refer to advance payments made by a firm whose benefits are acquired in the future. Payment for the goods is made in the current accounting period, but the delivery is received in the upcoming accounting period.read more may not be liquid. Therefore, including stock, such items will skew the current ratio from an immediate liquidity point of view. Quick ratio solves this problem by not taking inventory into account. It only considers the most liquid assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company’s balance sheet.read more, including money and cash equivalents, and receivables. A higher than the average industry ratio may imply that the company is investing too much of its resources in the business’s working capital, which may be more profitable elsewhere. However, if the quick ratio is lower than the industry average, the company is taking a high risk and not maintaining adequate liquidity.