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Ratio Analysis – Quick Ratio

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Ratio Analysis – Quick Ratio

quick ratio

What is the Quick Ratio?

It is an indicator of a company’s short-term liquidity position & its also known as liquid ratio. It measures a company’s ability to meet its short-term obligations with its most liquid assets.

Since it points out the company’s ability to instantly use its near-cash assets. Assets that can be converted quickly to cash to pay down their current liabilities. It is also called the Acid Test Ratio. An “Acid Test” is a slang term for a quick test that is designed to produce instant results. Hence, the name.

Understanding the Quick Ratio

It measures the dollar amount of liquid assets. Those are available against the dollar amount of current liabilities of a company. Liquid assets are those current assets that can be quickly converted into cash.

With minimal impact on the price that received in the open market. While the current liabilities are a company’s debts or obligations. Those are due to be paid to the creditors within one year.

A result of 1 is considered to be the normal quick ratio. It points out that the company is fully equipped with exactly enough assets. To be instantly liquidated to pay off its current liabilities. A company that has a quick ratio of less than 1 may not be able to fully pay off.

Its current liabilities in the short term. But a company that has a quick ratio higher than 1 can instantly get rid of its current liabilities. For example, a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets. Those are available to cover each $1 of its current liabilities.

But such numbers-based ratios offer insight into the viability. Certain aspects of a business may not provide a complete picture of the overall health of the business. It is important to look at other associated measures to use the true picture.

The Quick Ratio Calculation

The quick ratio or the generally accepted ‘norm’ for quick ratio is ‘1’.

Formula: Quick Assets or liquid assets / Current Liabilities

Here, quick assets means which are quickly convertible into cash. Current assets other than stock and prepaid expenses are considered as quick assets. Comparison of quick ratio with current ratio indicates the inventory holds ups.

To calculate this ratio, just locate each of the formula components on a company’s balance sheet. In the current assets and current liabilities sections. Plug the corresponding balance into the equation and also perform the calculation.

While calculating this ratio, just double-check the constituents that one is using in the formula. The numerator of liquid assets should include the assets. That can be easily converted to cash in the short-term. That is within 90 days or so without compromising on their price.

Inventory is not included in this ratio. Because many companies, in order to sell through their inventory in 90 days. Less would have to apply excessive discounts to motivate customers to buy quickly. Inventory is raw materials, components, and finished products.

Similarly, only accounts receivables can be collected within about 90 days. Should be considered. Accounts that are receivable refer to the money. That is owe something to a company by its customers. For goods or services that are already delivered.

Customer Payment Impact on the Quick Ratio

A business may have a large amount of money. As accounts receivable, which may move the quick ratio. However, if the payment from the customer is delayed due to unavoidable circumstances. If the payment has a due date that is a long period out. Like 120 days based on the terms of sale.

The company may not be able to meet its short-term liabilities. This may include the essential business expenses and accounts payable that need immediate payment. Despite having a healthy accounts receivable balance. The quick ratio might actually be too low. The business could be at risk of running out of cash.

On the other hand, a company could obtain a rapid receipt of payments from its customers. To secure longer terms of payment from its suppliers. Which would keep liabilities on the books longer. By converting the accounts receivable to cash faster. It may have a healthier quick ratio. It is fully equipped to pay off its current liabilities.

Whether the accounts that are receivable are a source of quick, ready cash remains a debatable topic, and depends on the credit terms.  The company extends to its customers. A company that needs advance payments.

Quick Ratio – Accounting Management

Allows only 30 days to the customers for payment will be in a better liquidity position. Then the one that gives 90 days. Additionally, a company’s credit terms with its suppliers also affect its liquidity position.

If a company gives its customers 60 days to pay. But has 120 days to pay its suppliers. Its liquidity position will be healthy as long as its receivables match or exceed its payables.

The other two components, cash & cash equivalents and marketable securities. These are usually free from such time-bound dependencies. However, to maintain precision in the calculation.

One should consider only the amount to be actually received in 90 days. Less under the normal terms. Early liquidation or premature withdrawal of assets. Like interest-bearing securities may lead to penalties or discounted book value.

Real-World Example

Publicly traded companies generally report the quick ratio figure. Under the “Liquidity or Financial Health” heading in the “Key Ratios” section of their quarterly reports.

Below is the calculation of the quick ratio. It is based on the figures that appear on the respective balance sheets of two leading competitors. Those are operating in the personal care industrial sector for the fiscal year ending of 2019:

(in $millions) Procter & Gamble Johnson & Johnson
Quick Assets(A) $15,238 $33,862
Current Liabilities(B) $30,011 $35,964
Quick Ratio(A/B) 0.51 0.94

With a quick ratio of 0.94. Johnson & Johnson appears to be in a decent position to cover its current liabilities. Though its liquid assets are not quite able to meet each dollar of short-term obligations. Procter & Gamble, on the other hand, may not be able to pay off its current obligations. By using only quick assets as its quick ratio is well below 1, at 0.51.

The Quick Ratio vs. Current Ratio

The quick ratio is more averse to change 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 very quickly. The current ratio, on the other hand, considers inventory and also 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. Prepaid expenses, though an asset. That cannot be used to pay for current liabilities. So they are omitted from the quick ratio.

The Frequently Asked Questions

Why is it called the “Quick” Ratio?

The Quick Ratio looks at only the most liquid assets. That a company has available to service short-term debts and obligations. Liquid assets are those that can quickly and easily be converted into cash. In order to pay those bills. Hence “quick”.

What assets are considered most “Quick”?

The “Quickest” or most liquid assets that are available by a company are cash. The cash equivalents such as money market investments. Followed by marketable securities that can be sold in the market.

At a moment’s notice through the company’s broker. Accounts that are receivable are also included. As these are the payments that are owed in the short-run to the company. From goods sold or services rendered that are due.

What is the difference between the Quick Ratio and other liquidity ratios?

The quick ratio only looks at the most liquid assets on a firm’s balance sheet. So gives the most immediate picture of liquidity that is available if needed in a pinch.

Making it the most conservative measure of liquidity. The current ratio also includes less liquid assets like inventories. The other current assets such as prepaid expenses.

What happens if the Quick Ratio indicates a company is not liquid?

In this case, a liquidity crisis can arise even at healthy companies. If circumstances arise that make it difficult to meet the short-term obligations. Such as repaying their loans and paying their employees or suppliers.

One example of a far-reaching liquidity crisis from recent history is the global credit crunch of the years 2007 to 2009. Where many companies found themselves unable to secure short-term financing.

To pay their immediate obligations. If new financing cannot be found. The company may be forced to liquidate assets in a fire sale. They are seeking bankruptcy protection.

So, this is the important information on topic Ratio Analysis – Quick Ratio. Here I have mentioned the meaning, understanding, calculation, Customer payment effect, also differences.

If any Queries or Questions is persisting then, please feel free to comment on the viewpoints.

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