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What is the quick ratio?
The quick ratio, also known as the acid-test ratio, measures the ability of a company to pay all of its outstanding liabilities when they come due with only assets that can be quickly converted to cash. These include cash, cash equivalents, marketable securities, short-term investments, and current account receivables.
The quick ratio is calculated by dividing the sum of cash and cash equivalents, short-term investments, and account receivables by the company’s current liabilities. These highly liquid investments are also called quick assets.
When a company has a quick ratio of less than 1, it has no liquid assets to pay its current liabilities and should be treated with caution. If the quick ratio is much lower than the current ratio, this means that current assets heavily depend on inventories. The quick ratio is more conservative than the current ratio, as it excludes inventories from current assets.
Since most companies use their long-term assets to generate income, selling them off not only seriously hurts the company but also shows potential investors that current operations are not generating enough profits to pay off current liabilities.
When a company has a quick ratio of 1, its quick assets are equal to its current assets. This also indicates that the company can pay off its current debts without selling its long-term assets. If a company has a quick ratio higher than 1, this means that it owns more quick assets than current liabilities.
As the quick ratio increases, so does the company’s liquidity. More assets can be quickly converted into cash, if necessary. This is a good sign for investors and an even better sign for creditors, as it assures them that they will be repaid on time.
However, a very high ratio is not always a good thing. It could mean that cash has accumulated but is stagnant, rather than being reinvested, repaid to investors, or otherwise put to productive use. Some tech companies generate huge revenues and therefore have quick ratios as high as 7 or 8. These companies have drawn criticism from activist investors who prefer that stockholders get a percentage of the revenue.
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Quick ratio example
A company’s quick ratio can be calculated using its balance sheet. Cogswell Cogs is applying for a loan to expand its operations, and the bank asks for a detailed balance sheet so that it can calculate a quick ratio for the company. Cogswell Cogs’s balance sheet includes the following accounts:
- Cash and equivalents: $15,000
- Accounts receivable: $10,000
- Inventories: $3,000
- Stock investments: $2,000
- Prepaid taxes: $600
- Current liabilities: $20,000
The bank calculates the company’s quick ratio like this:
Cash & equivalents ($15K) + short-term investments ($2K) + accounts receivable ($10K) / current liabilities ($20K) = 1.35
Based on the calculation above, the quick ratio is 1.35. This means that the company can pay off all of its current liabilities with quick assets and still have some quick assets remaining.