Quick Ratio Formula With Examples, Pros and Cons (2024)

What Is the Quick Ratio?

The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets.

Since it indicates the company’s ability to instantly use its near-cash assets (assets that can be converted quickly to cash) to pay down its current liabilities, it is also called the acid test ratio. An "acid test" is a slang term for a quick test designed to produceinstant results.

Understanding the Quick Ratio

The quick ratio measures the dollar amount ofliquid assetsavailable 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 received in theopen market, while current liabilities are a company's debts or obligations that are due to be paid to creditors within one year.

A result of 1 is considered to be the normal quick ratio. It indicates 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, while a company having a quick ratio higher than 1 can instantly get rid of its current liabilities. For instance, a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover each $1 of its current liabilities.

While such numbers-based ratios offer insight into the viability and certain aspects of a business, they may not provide a complete picture of the overall health of the business. It is important to look at other associated measures to assess the true picture of a company's financial health.

Quick Ratio Formula

There's a few different ways to calculate the quick ratio. The most common approach is to add the most liquid assets and divide the total by current liabilities:

$\begin{aligned}&\textbf{Quick Ratio}\mathbf{=}\frac{\textbf{``Quick Assets''}}{\textbf{Current Liabilities}}\end{aligned}$​QuickRatio=CurrentLiabilities“QuickAssets”​​

Quick assets are defined as the most liquid current assets that can easily be exchanged for cash. For most companies, quick assets are limited to just a few types of assets:

$\begin{aligned}&\textbf{Quick Assets}\mathbf{=}\textbf{Cash}\mathbf{+}\textbf{CE}\mathbf{+}\textbf{MS}\mathbf{+}\textbf{NAR}\\&\textbf{where:}\\&\text{CE}=\text{Cash equivalents}\\&\text{MS}=\text{Marketable securities}\\&\text{NAR}=\text{Net accounts receivable}\end{aligned}$​QuickAssets=Cash+CE+MS+NARwhere:CE=CashequivalentsMS=MarketablesecuritiesNAR=Netaccountsreceivable​

Depending on what type of current assets a company has on its balance sheet, a company may also calculate quick assets by deducting illiquid current assets from its balance sheet. For example, consider that inventory and prepaid expenses may not be easily or quickly converted to cash, a company may calculate quick assets as follows:

$\begin{aligned}&\textbf{Quick Assets}\mathbf{=}\textbf{TCA}\mathbf{-}\textbf{Inventory}\mathbf{-}\textbf{PE}\\&\textbf{where:}\\&\textbf{TCA}=\text{Total current assets}\\&\textbf{PE}=\text{Prepaid expenses}\end{aligned}$​QuickAssets=TCA−Inventory−PEwhere:TCA=TotalcurrentassetsPE=Prepaidexpenses​

Regardless of which method is used to calculate quick assets, the calculation for current liabilities is the same as all current liabilities are included in the formula.

Components of the Quick Ratio

Cash

Cash is among the more straight-forward pieces of the quick ratio. A company should strive to reconcile their cash balance to monthly bank statements received from their financial institutions. This cash component may include cash from foreign countries translated to a single denomination.

Cash Equivalents

Cash equivalents are often an extension of cash as this account often houses investments with very low risk and high liquidity. Cash equivalents often include but may not necessarily be limited to Treasury bills, certificates of deposits (being mindful of options/fees to break the CD), bankers' acceptances, corporate commercial paper, or other money market instruments.

In publication by the American Institute of Certified Public Accountants (AICPA), digital assets such as cryptocurrency or digital tokens may not be reported as cash or cash equivalents.

Marketable Securities

Marketable securities, 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 or less under normal terms. Early liquidation or premature withdrawal of assets like interest-bearing securities may lead to penalties or discounted book value.

Net Accounts Receivable

Whether accounts receivable is a source of quick, ready cash remains a debatable topic, and depends on the credit terms that the company extends to its customers. A company that needs advance payments or allows only 30 days to the customers for payment will be in a better liquidity position than a company that gives 90 days.

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

The total accounts receivable balance should be reduced by the estimated amount of uncollectible receivables. As the quick ratio only wants to reflect the cash that could be on hand, the formula should not include any receivables a company does not expect to receive.

Current Liabilities

The quick ratio pulls all current liabilities from a company's balance sheet as it does not attempt to distinguish between when payments may be due. The quick ratio assumes that all current liabilities have a near-term due date. Total current liabilities are often calculated as the sum of various accounts including accounts payable, wages payable, current portions of long-term debt, and taxes payable.

Quick Ratio vs. Current Ratio

The quick ratio is more conservative 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 in a short period of time. The current ratio, on the other hand, considers inventory and 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, cannot be used to pay for current liabilities, so they're omitted from the quick ratio.

Advantages and Limitations of the Quick Ratio

The quick ratio has the advantage of being a more conservative estimate of how liquid a company is. Compared to other calculations that include potentially illiquid assets, the quick ratio is often a better true indicator of short-term cash capabilities.

The quick ratio is also fairly easy and straightforward to calculate. It's relatively easy to understand, especially when comparing a company's liquidity against a target calculation such as 1.0. The quick ratio can be used to analyze a single company over a period of time or can be used to compare similar companies.

There are several downsides to the quick ratio. The financial metric does not give any indication about a company's future cash flow activity. Though a company may be sitting on $1 million today, the company may not be selling a profitable good and may struggle to maintain its cash balance in the future. There are also considerations to make regarding the true liquidity of accounts receivable as well as marketable securities in some situations.

Example of the Quick Ratio

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

Below is the calculation of the quick ratio based on the figures that appear on the balance sheetsof two leading competitors operating in the personal care industrial sector, P&G and J&J, for the fiscal yearending in 2021.