What is the quick ratio?
In finance, the quick ratio definition is the indicator that represents a company’s short-term liquidity position. Also known as the liquidity ratio or the acid-test ratio, it measures the company’s ability to pay short-term liabilities by selling its quick assets.
These are assets that can be quickly converted into cash. Quick assets include actual cash, cash equivalents, accounts receivable, short-term investments and marketable securities. If a business owns enough quick assets to cover its current liabilities, it means it can pay off its obligations without the need to sell any of its long-term assets.
Commonly, a normal quick ratio is considered to be 1:1 or higher. However, it can vary depending on the industry the business operates in. A company with a quick ratio of less than 1 cannot currently pay back its existing liabilities in full. Generally, the higher the ratio, the greater the company's liquidity.
The quick ratio is considered to be one of the most reliable tools to assess the liquidity position of a company.
Where have you heard about the quick ratio?
Typically, publicly traded companies publish their quick ratio figure in quarterly reports. It is generally placed in the “Key Ratios” section under the “Liquidity/Financial Health” heading.
The quick ratio is usually seen as a barometer of a company’s capability to pay its current obligations. Investors, financial analysts, suppliers and lenders use the ratio to evaluate the company's financial health against other companies in the same industry or to track how the company's short-term solvency has changed over time. A well-defined quick ratio is an indicator of sound business performance and competence that result in continuous growth.
What you need to know about the quick ratio…
As mentioned before, the quick ratio is usually referred to as the acid-test ratio. This name derives from the historical implementation of acid employed by the early miners in order to test metals for gold. If metal began corroding, it was a base metal of no value. Conversely, if the metal passed the acid test, it was real gold.
It is important not to confuse the quick ratio with the current ratio. While the first term only regards “quick assets,” the latter includes all current assets and current liabilities.
When calculating the quick ratio, inventory is usually not included as it is more difficult to sell or turn into cash. However, for some companies, inventories are considered a quick asset. Nevertheless, these cases are extremely rare and depend solely on the nature of the business.
What is the quick ratio formula? The quick ratio is calculated as follows:
In a situation where the company's financial statements don’t give a breakdown of quick assets on its balance sheet, the quick ratio can be calculated as follows:
A higher quick ratio is more favourable for a company, as it indicates that the business has more quick assets than current liabilities. For instance, a quick ratio of 1 shows that a company’s quick assets equal current liabilities. A ratio of 2 indicates that the firm owns twice as many quick assets than current liabilities.
The higher the ratio, the higher the company’s liquidity, meaning that more assets can be quickly converted into cash if such a need arises. This is an important indicator for investors and traders who are looking for sound businesses to invest in.