The quick ratio only includes highly-liquid assets or cash equivalents as current assets. Both types of liquidity ratios are calculated under a hypothetical scenario in which a company must pay off all existing current liabilities that have come due using its current assets. This is because the formula’s numerator (the most liquid current assets) will be higher than the formula’s denominator (the company’s current liabilities).
The quick ratio, also called an acid-test ratio, measures a company’s short-term liquidity against its short-term obligations. Essentially, the ratio seeks to figure out if a company has enough liquid assets (cash or things that can easily be converted into cash) to cover its current liabilities and impending debts. A key point to note, though, is this isn’t a test to see how much debt a company has or if it could seek financing to cover any current debts.
Features of the quick ratio
A higher quick ratio signals that a company can be more liquid and generate cash quickly in case of emergency. It indicates that the company is fully equipped with exactly enough assets to be instantly liquidated to pay off its current liabilities. For instance, a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover each $1 of its current liabilities. Since it indicates the company’s ability to instantly use its near-cash assets (assets that can be converted quickly to cash) to pay down its current liabilities, it is also called the acid test ratio.
- Illiquid assets are excluded from the calculation of the quick ratio, as mentioned earlier.
- This may include cash and savings, marketable securities (stocks and bonds), and accounts receivable (money owed to the company by customers and clients).
- For example, a company with a low ratio might not be at too much of a risk if it has non-core fixed assets on standby that could be sold relatively quickly.
- A quick ratio higher than 1 may be considered to be a reduced financial risk.
- Early liquidation or premature withdrawal of assets like interest-bearing securities may lead to penalties or discounted book value.
For example, a company with a low ratio might not be at too much of a risk if it has non-core fixed assets on standby that could be sold relatively quickly. In publication by the American Institute of Certified Public Accountants (AICPA), digital assets such as cryptocurrency or digital tokens may not be reported as cash or cash equivalents. Keep in mind that industry, location, markets, etc. can also play a role in what a good quick ratio is. As a business, you should aim for a ratio that is greater than or equal to one. She also suggests the best insights come from tweaking your analysis to discover new ways to improve.
How Do the Quick and Current Ratios Differ?
Though a company may be sitting on $1 million today, the company may not be selling a profitable good and may struggle to maintain its cash balance in the future. There are also considerations to make regarding the true liquidity of accounts receivable as well as marketable securities in some situations. This variation is less strict as it subtracts inventory from current assets. It’s often used when financial statements don’t provide a breakdown of your quick assets. Inventory is considered an illiquid asset meaning it can’t be converted to cash quickly. This may include cash and savings, marketable securities (stocks and bonds), and accounts receivable (money owed to the company by customers and clients).
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Components of the Quick Ratio
For example, the current ratio is great at giving high ratio scores for companies with large inventories. On the other hand, the quick ratio leans more conservatively, especially for inventory-reliant business models. The benefit of lumping all debts together is it’s more accessible because people outside of the company may not have access to details like when a payment is due.
Related Accounting and Finance Skills
If a company’s financials don’t provide a breakdown of its quick assets, you can still calculate the quick ratio. You can subtract inventory and current prepaid assets from current assets, and divide that difference by current liabilities. The quick ratio communicates how well a company will be able to pay its short-term debts using only the most liquid of assets. The ratio is important because it signals to internal management and external investors whether the company will run out of cash. The quick ratio also holds more value than other liquidity ratios such as the current ratio because it has the most conservative approach on reflecting how a company can raise cash. The quick ratio pulls all current liabilities from a company’s balance sheet as it does not attempt to distinguish between when payments may be due.
What Is Quick Ratio? Learn How to Swiftly Calculate This Metric
This shows that, disregarding profitability or income, Johnson & Johnson appears to be in better short-term financial health in respects to being able to meet its short-term debt requirements. The quick ratio measures the dollar amount of liquid assets available against the dollar amount of current liabilities of a company. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are generally more difficult to turn into cash. The quick ratio considers only assets that can be converted to cash in a short period of time. The current ratio, on the other hand, considers inventory and prepaid expense assets. In most companies, inventory takes time to liquidate, although a few rare companies can turn their inventory fast enough to consider it a quick asset.
Find out about the quick ratio and how it can help businesses manage the risk of having insufficient cash to pay debts. Does your business have enough liquid assets to cover short-term liabilities in a pinch? Keep reading to learn the quick ratio definition, how to calculate your ratio, and more.
What is the quick ratio and how is it calculated?
A company can’t exist without cashflow and the ability to pay its bills as they come due. By measuring its quick ratio, a company can better understand what resources they have in the very short-term in case they need to liquidate current assets. Though other liquidity ratios measure a company’s ability to be solvent in the short-term, the quick ratio is among the most aggressive in deciding short-term liquidity capabilities.
