What is Quick Ratio and what is its significance?

In finance, the quick ratio is a metric used to assess a company's liquidity by comparing its short-term debt to its available liquid assets within the next 90 days. It depicts how a company can use its liquid assets to pay its immediate debts. This ratio provides valuable insight for management in determining their ability to meet their current debt commitments. Furthermore, it can utilize this ratio to identify opportunities to grow its cash and short-term investments. This ratio calculates a company's existing assets by its current debts.

Quick ratio definition 

It refers to the liquid assets listed on a company's balance sheet. Cash and equivalents, account receivable and marketable securities fall under this category. By contrast, a company's current liabilities are obligations that must be paid to its creditors within a year. Short-term debt, outstanding income taxes, accounts payable, dividends payable, and accumulated expenses are all examples of current liabilities that can be found on a balance sheet.

Calculation of quick ratio

The quick ratio is a liquidity ratio that measures the company's capacity to meet its short-term obligations by comparing its liquid assets (cash and cash equivalents, marketable securities, and accounts receivable) to its current liabilities.

quick ratio = (Cash + Short Term Marketable Securities + Accounts Receivables) / current liabilities

The quick ratio is more rigorous when comparing short-term liquidity measures than the current ratio. Cash-convertible assets can be turned into cold hard cash in less than ninety days. The critical distinction is to calculate the quick ratio rather than including inventory and prepaid expenses as part of current Assets, as is done with the current ratio.

Since it is expected that the company's equity may not be immediately recognized, inventory is not included. Inventory liquidation will be more complex and time-consuming in such a scenario. Raw materials or work-in-progress may make up the stockpile.

If the ratio is more than 1, the company is in good financial condition and can meet its short-term obligations with the help of its liquid assets. Be wary of relying too heavily on the quick ratio without doing additional research. For instance, seasonal businesses that aim to steady production may have a quick low ratio during down-sales periods but a more excellent ratio during busy ones. In these cases, it may be challenging to ascertain the proper financial health of the business.

Importance of quick ratio

It is one of the most important ratios to consider to analyze a company’s financial health. It foreshadows the firm's capacity to settle its immediate liabilities on short notice.

● Analysts and lenders consider quick ratio because it tells them the percentage of the firm’s debts that could be paid off by converting assets to cash. It shows the firm is capable of dealing with changing business environment.

● The ratio provides a more accurate picture of the company's liquidity status because it does not include closing stock, which may not always be required to be taken as a liquid. Closing stock is the amount of unsold stock that remains with the business on a given day.

● This ratio will help offer the company a more reliable payback capability against the current ratio, including closing stock, in a declining industry, which may typically have a very high closing stock level.

Limitations of quick ratio

While the quick ratio might be a valuable indicator of a company's liquidity, it is not universally accepted. The following are some of the problems with this financial ratio:

● An organization's true liquidity status cannot be determined with absolute certainty using the quick ratio alone. If management were to rely only on this monetary ratio, the results could be disastrous. The biggest problem with the quick ratio is that it doesn't tell us anything about the company's working capital, which is essential in determining its underlying financial status.

● Inventory is not included in the quick assets used in its calculation. While it's true that stockpiling might slow down a company's cash flow, there are some businesses where it's trivial to unload inventory at a profit. Therefore, management may be fooled into underestimating the company's ability to meet its short-term debt obligations if they rely primarily on the quick ratio.

● The quick ratio has the drawback of being insensitive to the magnitude and timing of cash flows within an organization. This can lead to a misunderstanding of the company's cash flow and a failure to account for unexpected expenses, both of which can have lasting effects.

FAQs

Q. What does a company's quick ratio of 5 indicate?

When a company's quick assets are five times its current liabilities, it means the company can pay off its current liabilities five times over. It also signifies that the corporation has enough cash to meet its short-term debt obligations.

Q. What will happen if the quick ratio rises?

A higher quick ratio is preferable in most cases. The company's most liquid current assets (the numerator) will exceed its current liabilities (the denominator) in the formula. Companies with a more excellent fast ratio are more likely to be liquid and produce cash quickly in the event of a cash crunch.

Q. What is the formula for the current ratio?

One can calculate the current ratio by dividing the current assets by the current liabilities. The quick ratio only considers highly liquid assets as part of current assets; that’s not true for the current ratio.