Quick Ratio Definition: How to Calculate Quick Ratio

Also known as the acid test ratio, the quick ratio measures how much cash or how many assets a company has access to that it could use to pay its short-term obligations. A company’s quick ratio can indicate high or low liquidity—the availability of liquid assets (cash)—and be a sign of a company’s financial health when taken into consideration with other relevant factors.

Quick ratio is one of many financial ratios you can calculate to help you manage your business better. Additionally, knowing financial metrics like your company’s liquidity ratio can increase your appeal to potential lenders who are considering your company as a candidate for a loan, whether for short-term investments or long-term commitments.

The first step to calculating your company’s quick ratio is to collect some information from the company’s balance sheets or other financial statements. Here are the total values you will need:

• Accounts receivable (AR): When a company sells something, whether it’s a service or a product, and it hasn’t received payment yet, that money sits in accounts receivable. It’s the balance due to the company because of the sale of those items, and they’re noted as a current asset.
• Current assets (CA): This is a company’s assets—including cash, accounts receivable, inventory, and similar items—that a company goes through within a year.
• Cash equivalents (CE): You find cash equivalents on a company’s balance sheet. They give you an idea of any items or assets that a company owns that they, if necessary, could turn into cash.
  
• Current liabilities (CL): This is what a company has to pay—their financial obligations—within a year. These can balance out with a company’s current assets.
• Inventory (I): Inventory refers to not only the items that a company sells, but also the raw materials used to produce those goods.
• Marketable securities: Similar to cash equivalents, marketable securities are also items a company can convert to cash. The difference here is that marketable securities are financial instruments, such as stocks or securities, and there may be a cost involved in selling them.
• Prepaid expenses (PE): A prepaid expense is any expense like rent, bills, utilities, and the like, that a company pays for before they’re actually due.

The second step in calculating a quick ratio is to apply the relevant values to one of two possible quick ratio formulas. Each of the two separate formulas for quick ratio uses a different combination of values. The first formula is QR=(CE+MS+AR)/CL, and most businesses prefer this ratio calculation because it doesn’t require the company to have sold a large amount of inventory to achieve a higher ratio. The second formula is QR=(CA-I-PE)/CL.

Quick ratio can indicate a company’s liquidity position (available cash). Knowing your company’s liquidity is critical because it can indicate how quickly the company could get out of its current debt in a scenario in which sales have slumped or the economy has taken a dive. If a company’s quick ratio is higher, then the company’s liquidity is good, and it has the ability to pay off debts and other current obligations quickly if necessary. If a company has a lower quick ratio, then it means it might struggle to pay off debts and might not have enough working capital.

Once you know your company’s current ratio, you can assess your total current liabilities and take conservative measures to adjust accordingly. For example, if your ratio analysis determines that your quick ratio is too high, you might decide to use some of your liquid assets to increase efficiency or improve your cash ratio. You might also consider whether it’s desirable or even possible to do an inventory turnover to generate cash flow.

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

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