What is Quick Ratio?
The Quick Ratio measures the short-term liquidity of a company by comparing the value of its cash balance and current assets to its near-term obligations.
Otherwise referred to as the “acid test” ratio, the quick ratio is distinct from the current ratio since a more stringent criterion is applied to the current assets in its calculation.
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How to Calculate Quick Ratio (Step-by-Step)
The quick ratio compares the short-term assets of a company to its short-term liabilities to evaluate if the company would have adequate cash to pay off its short-term liabilities.
Conceptually, the quick ratio answers the question:
- “Does the company have enough cash to pay off its short-term liabilities, such as debt obligations soon coming due?
The core components of the metric include the following line items:
- Current Assets: Cash & Equivalents, Marketable Securities, Accounts Receivable (A/R)
- Current Liabilities: Accounts Payable (A/P), Short-Term Debt
In the calculation of the quick ratio, the items that are considered as part of current assets are under more stringent rules — which is based on the notion that certain assets are more difficult to liquidate quickly, such as inventory, or may be difficult to sell at the same or relatively similar value (i.e. in a scenario where no substantial discount is required to sell the asset).
The inclusion of illiquid current assets within the calculation can potentially cause a misleading portrayal of the company’s financial condition, as it may misleadingly portray a company as being better able to meet its short-term obligations than in reality.
Quick Ratio Formula
The formula for calculating the quick ratio is as follows.
For example, let’s imagine that a company has the following balance sheet data:
- Cash = $20 million
- Marketable Securities = $10 million
- Accounts Receivable (A/R) = $20 million
- Inventory = $40 million
- Accounts Payables = $30 million
- Short-Term Debt = $10 million
Next, the required inputs can be calculated using the following formulas.
- Current Assets = $20 million + $10 million + $20 million = $50 million
- Current Liabilities = $30 million + $10 million = $40 million
As mentioned earlier, illiquid assets are excluded in the calculation of the quick ratio, which is why inventory is not included.
Lastly, we’ll divide the current assets by the current liabilities to arrive at the quick ratio:
- Quick Ratio = $50 million ÷ $40 million = 1.25x
Quick Ratio vs. Current Ratio: What is the Difference?
Both 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.
However, one major difference between the two is that the quick ratio includes only the current assets that can be converted into cash within 90 days or less, whereas the current ratio includes all current assets that can be converted into cash within one year.
The quick ratio is thus considered to be more conservative than the current ratio since its calculation intentionally ignores more illiquid items like inventory.
How to Interpret the Quick Ratio (High vs. Low)
While dependent on the specific industry, the quick ratio should exceed >1.0x for the vast majority of industries.
The two general rules of thumb for interpreting the quick ratio are as follows.
- Higher Ratio → Sufficient Coverage of Current Liabilities
- Lower Ratio → Insufficient Coverage of Current Liabilities
The quick ratio measures if a company, post-liquidation of its liquid current assets, would have enough cash to pay off its immediate liabilities — so, the higher the ratio, the better off the company is from a liquidity standpoint.
If the ratio is low, the company should likely proceed with some degree of caution, and the next step would be to determine how and how quickly more capital could be obtained.
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 fact, such a company may be viewed favorably by the equity or debt capital markets and be able to raise capital easily.
But a higher ratio should NOT automatically be interpreted as a positive sign without further research into the company’s drivers – e.g. a company can have a healthy quick ratio of 2.0x, yet the majority of its current assets are A/R where the collection of payment from customers is not always guaranteed.
While a higher amount of asset collateral is perceived positively under a liquidation scenario, most companies focus more on forward-looking performance like free cash flow (FCF) generation and profit margins, although all of these aspects are ultimately interconnected.
Quick Ratio Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Quick Ratio Calculation Example
Suppose a company has the following balance sheet financial data in Year 1, which we’ll use as our assumptions for our model.
- Cash & Equivalents: $20m
- Marketable Securities: $15m
- Accounts Receivable (A/R): $25m
- Inventory: $80m
- Accounts Payable: $65m
- Short-Term Debt: $85m
In Year 1, the quick ratio can be calculated by dividing the sum of the liquid assets ($20m Cash + $15m Marketable Securities + $25m A/R) by the current liabilities ($150m Total Current Liabilities).
- Quick Ratio, Year 1: $60m ÷ $150m = 0.4x
The company appears not to have enough liquid current assets to pay its upcoming liabilities.
From Year 2 to Year 4, we’ll use a step function for each B/S line item with the following assumptions.
- Cash and Cash Equivalents: +$5m
- Marketable Securities: +$2m
- Accounts Receivable (A/R): +$3m
- Inventory: +$25m
- Accounts Payable: +$5m
- Short-Term Debt: +$10m
Upon dividing the sum of the cash and cash equivalents, marketable securities, and accounts receivable balance by the total current liabilities balance, we arrive at the quick ratio for each period.
At the end of the forecast period, Year 4, our company’s ratio remains relatively unchanged at 0.5x, which is problematic as the concerns regarding short-term liquidity remain.
However, the current ratio in Year 4 is 1.3x, more than double the 0.5x ratio from earlier.
While the high inventory balance and growth benefit the current ratio, the quick ratio excludes illiquid current assets such as inventory. The gap between the current ratio and quick ratio stems from the inventory line item, which comprises a significant portion of the total current assets balance.
The inventory balance of our company expands from $80m in Year 1 to $155m in Year 4, reflecting an increase of $75m.
Our company’s current ratio of 1.3x is not necessarily positive, since a range of 1.5x to 3.0x is usually ideal, but it is certainly less alarming than a quick ratio of 0.5x.
On one note, the inventory balance can be helpful when raising debt capital (i.e. collateral), as long as there are no existing liens placed on the inventory or any other contractual restrictions.
Yet, the broader concern here is that the cause of the accumulating inventory balance is due to declining sales or lackluster customer demand for the company’s products/services.