Quick Ratio

The quick ratio also known as acid test ratio is a part of liquidity ratio which helps in evaulating a companys ability to pay off its current liabilities when they come due with only quick assets. Quick assets can be any current assets that can be converted to cash within three months or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets.

Quick Ratio Formula

Mathematical formula to calculate quick ratio is:

Quick Ratio = Liquid Assets / Current Liabilities

It can also be written as:

Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

Liquid assets that are mentioned in the numerator of the formula should be taken into account carefully i.e. it should include only those assets which can be converted into cash on a short term basis (maximum 3 months). Even the account receivables can not be treated as liquid if they’re not expected to be received within the three months time period. Inventory cannot be treated as liquid asset as the sale of it is uncertain and the company may have to compromise with the valuation if it hurries up to sell the inventory in such short time.

Sometimes, the balance sheet of some companies doesn’t give a proper breakdown of the quick assets which makes it difficult to calculate quick ratio. But it is still possible to calculate the quick ratio if the inventory and current prepaid expenses (if there are any) are decuted from the total current assets. This gives us the formula:

Quick Ratio = Total current assets – Inventory – Current prepaid expenses / Current Liabilities

Example of Quick Ratio

Consider Ferdinand’s Garage is applying for a loan for expansion of the garage. The bank asks Ferdinand to provide it with a detailed balance sheet, so it can compute the quick ratio. Ferdinand’s balance sheet included the following accounts:

Cash: $12,000

Accounts Receivable: $4,000 (expected to receive within 3 months)

Inventory: $6,000

Stock Investments: $1,000

Prepaid taxes: $500

Current Liabilities: $16,000

To calculate the quick ratio of the garage, bank will put the figures in the formula:

Quick Ratio = $12000 + $4000 + $1000/$16000

Quick Ratio = 1.06

The figure 1.06 clearly suggests that Ferdinand can pay off his current liabilities with the quick assets available with him and still will be left with some of the quick assets.