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.
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.
Calculating the quick ratio involves dividing a company’s current cash & equivalents (e.g. marketable securities) and accounts receivable by its current 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?
Similar to the current ratio, which also compares current assets to current liabilities, the quick ratio is categorized as a liquidity ratio.
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.