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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 financial position to instantly use its near cash assets (that is, liquid assets) to get rid of its current liabilities, it is also called as the acid test ratio. An acid test is a quick test designed to produce instant results, hence the name.

BREAKING DOWN 'Quick Ratio'

The quick ratio measures the dollar amount of liquid assets available with the company against the dollar amount of its current liabilities. Liquid assets are the assets that can be quickly converted into cash with minimal impact to the price received in the open market, while current liabilities are a company's debts or obligations that are due to be paid to creditors within one year.

Mathematically, quick ratio is calculated as follows:

Quick Ratio = Liquid Assets / Current Liabilities, or

Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

While calculating the quick ratio, one should be careful about the constituents to be considered in the formula. The numerator that comprises of liquid assets should include the assets that can be easily converted to cash in the short-term (like, within 90 days) without compromising on their price. Similarly, only those accounts receivable should be considered which can be realized in the short term. Accounts receivable refers to the money that is owed to a company by its customers for goods or services already delivered. Inventory is not included in the equation, because its liquidation or sale is uncertain and attempts to instantly liquidate it can lead to compromising on valuations and accept a lower price than the book value. Inventory includes raw materials, components and finished products.

Interpreting Quick Ratio

A figure of 1 is considered to be the normal quick ratio, as it indicates that the company is fully equipped with sufficient assets that can 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 the company has $1.50 of liquid assets available to cover each $1 of its current liabilities.

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

For instance, a business may have a large amount of money as accounts receivable which may bump up the quick ratio. However, if the payment from the customer if delayed due to unavoidable circumstances, or if the payment is due after a long period (like, 120 days) based on terms of sale, the company may not be able to meet up its short term liabilities which may include essential business expenses and accounts payable that may be due for immediate payment. Despite having a healthy quick ratio, the business is actually at the verge of running out of cash. On the other hand, if the company negotiates rapid receipts of payments from its customers and secures longer terms of payments from its suppliers, it may have a very low quick ratio but may be fully equipped to pay off its current liabilities.

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 the one that gives 90 days. Additionally, a company’s credit terms with its suppliers also affects its liquidity position. If a company gives its customers 60 days to pay, but has 120 days to pay its suppliers, its liquidity position may be reasonable.

The other two components, cash and marketable securities, are usually free from such time-bound dependencies. However, to maintain precision in calculation, one should consider only the amount to be actually received in due course of time, as early liquidation or pre-mature withdrawal (of assets like interest bearing securities) may lead to credit losses and discounted book value.

Example of Quick Ratio

Publicly listed companies generally report the quick ratio figure under the “Liquidity/Financial Health” heading in the “Key Ratios” section of their quarterly reports. Another commonly reported ratio is the current ratio, which includes all current assets in its calculation including inventory.

Below is the calculation of quick ratio based on the figures that appear on the respective balance sheets of three leading competitors operating in the personal care industrial sector for the fiscal year ending 2017:

 (in millions)

Procter & Gamble

Johnson & Johnson

Kimberly-Clark Corp.

Quick Assets

(A)

$26,490

$43,090

$5,210

Current Liabilities

(B)

$30,210

$30,540

$14,210

Quick Ratio

(A/B)

0.88

1.41

0.367

With a quick ratio of higher than 1, Johnson & Johnson appears to be well positioned to cover its current liabilities and has liquid assets available to cover each dollar of short-term debt. However, Procter & Gamble and Kimberly-Clark may not be able to pay off their current debts using only quick assets since both companies have a quick ratio below 1.

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