Quick ratio or acid test ratio is one of the liquidity ratios which measures a company’s ability to pay its short-term, current liabilities with its most liquid (or quick) assets.

Quick assets are current assets which can be converted to cash quickly (within 90 days). Examples of quick assets include cash equivalents like treasury bills or government bonds, short term investments, marketable securities like stocks and bonds, current accounts receivable and actual cash in the bank as well.

  • Liquidity is a measure of how easily a company meets its Short-Term Obligations with its Current Assets.
  • The less time it takes to convert an Asset into Cash, the more liquid this Asset is.
  • On the balance sheet Assets are presented in the order of liquidity, so the most liquid Asset is Cash, followed by Cash Equivalents, Marketable Securities, Accounts Receivable and so on.
  • The quick ratio is sometimes called the acid test ratio in reference to the use of acid to test metals for gold by the early miners. It was pure gold if the metal passed the acid test, but if the metal was corroded by the acid, it was a base metal and not real gold.

How to calculate quick ratio?

Quick ratio is calculated by dividing liquid/quick assets by current liabilities:

Q = \frac{A}{L}

Where Q = quick ratio, A is liquid/quick assets(the sum of Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) and L is current liabilities.

  • Cash Equivalents are Treasury Bills, Commercial Papers, Money Market Funds and Short-term Government Bonds. These money market securities have very high liquidity, but low return profile, since the risks related to these instruments are minimal or close to zero.
  • Marketable Securities are any financial instruments, such as stocks, certificates of deposit or bonds, that are easily sold or bought on public exchanges.
  • Accounts Receivable is the right to receive money from the debtors who have purchased company’s goods or services but haven’t paid yet. As a rule, the credit period varies between a couple of days and a couple of months. Inventory is not included in this equation, because its sale is uncertain and attempts to rapidly liquidate it can cause selling it for a lower price than its book value.
  • Quick Liabilities are short-term obligations, such as accounts payable, notes payable, accrued expenses, or a current portion of long-term debt that must be paid within a year.

How to interpret quick ratio?

Generally, the Quick Ratio should be 1 or higher. That means that a company would be able to cover its Short-Term Debt with its Liquid Assets.

If the Quick Ratio is below 1 that means that a company struggles to meet current obligations using liquid assets. There are several reasons why the Quick Ratio is too low:

  • A company is over-leveraged, i.e. it has borrowed too much money in relation to its ability to pay it back
  • A company collects Accounts Receivable too slowly or inefficiently
  • A company pays Accounts Payable too soon

Higher Quick Ratio means that a company collects account receivable efficiently and quickly turns them into cash, is not over-indebted and is able to pay its short-term debts with its most liquid assets.

However, at first sight it might seem that the higher quick ratio is the better business is doing but it’s not completely correct. When the Quick Ratio is significantly more than 1:1 that suggests that the company keeps too much resources in liquid assets instead of investing it and generating profit.

On the over hand, profit maximization is one of the top priorities of any business and if the company invests all the money, it won’t have enough cash to run its daily activities, i.e. pay salaries, tax, rent, etc. Relationship between profitability and liquidity can be described as inversely proportional.

The higher the liquidity the lower will be the profitability and vice versa. So, one of the important tasks for a financial manager, is to find the balance between liquidity and profitability.

Example of quick ratio calculation

COMPANY A BALANCE SHEET
Cash $50,000 Accounts Payable $40,000
Cash Equivalents $20,000 Accrued Expenses $30,000
Common Stocks $5,000 Notes Payable $10,000
Accounts Receivable $40,000 Current Long-Term Debt $25,000
TOTAL $115,000 TOTAL $105,000
Q = \frac{\$115,000}{\$105,000} = 1.1

A quick ratio of 1.1 means that Company A has enough Liquid Assets to pay its Current Liabilities. For each $1 of Short-Term Debt it has $1.1 of Liquid Assets.