The quick ratio is a liquidity indicator used to assess an organization's ability to meet its short-term obligations with its most liquid assets. It is also known as the "acid test ratio" since it reveals whether or not a corporation can meet its short-term obligations by quickly converting its liquid assets into cash. The acid test is slang for any fast test intended to give immediate findings.
The Quick Ratio: What You Need to Know
The quick ratio evaluates the dollar amount of liquid assets available against the dollar amount of current liabilities of a corporation. A company's current liabilities are its debts or obligations that are required to be paid to creditors within a year.
In contrast, a company's liquid assets are its existing assets that can be easily turned into cash with minimum influence on the price obtained in the open market. The usual quick ratio is regarded as a result of 1. In other words, the corporation has the number of liquid assets needed to settle its present debts in the event of a sudden need to do so.
A Look at the Quick Ratio's Components
Cash
Part of the simplicity of the quick ratio is its emphasis on available cash. A business must verify that their money on hand agrees with the bank statements they get regularly. This monetary element may consist of localized versions of currency from other countries.
Cash Equivalents
Investments with low risk and high liquidity profile, such as those held in a cash equivalents account, are frequently considered a convenient extension of cash. Treasury bills, certificates of deposit, bankers' acceptances, corporate commercial paper, and other money market instruments are typical examples of cash equivalents.
Cryptocurrency and other digital tokens may not be recorded as cash or cash equivalents in a publication by the American Institute of Certified Public Accountants.
Transferable Securities
Most marketable securities don't have any such time-sensitive dependencies. However, for accuracy's sake, only the amount expected to be received in 90 days or fewer under standard conditions should be used. An early liquidation or withdrawal may incur fines or a reduction in book value for assets with a future income stream, such as interest-bearing securities.
Negative Accounts Receivable
Accounts receivable's potential as a source of available cash depends on the company's policies on customer credit. In terms of cash flow, a business that requires payment in advance or offers its clients only 30 days to pay would be in better shape than one that provides them with 90 days.
On the other side, a business may extend the period that obligations remain on the books by negotiating faster payment from consumers and longer payment terms from suppliers. It may improve its quick ratio and ability to meet its current liabilities if it can turn accounts receivable into cash more quickly.
Current Ratio vs. Quick Ratio
Since inventories and other current assets are typically more challenging to convert into cash, the quick ratio tends to be more cautious than the current ratio. This ratio takes into account just liquid assets. Contrarily, the current balance considers assets like inventories and prepaid expenses. Only a tiny percentage of businesses can turn list fast enough to consider it rapid support because of how long it takes to sell. Although they are an asset, prepaid costs cannot be utilized to settle current liabilities and are thus excluded from the quick ratio calculation.
Benefits and Drawbacks of the Quick Ratio
Compared to other measures of a company's liquidity, the quick ratio tends to be more cautious. The quick ratio is often a measure of short-term cash capability more accurately than other estimates that may include potentially illiquid assets. Calculating the quick ratio is similarly simple and rapid. It's simple to grasp, especially when evaluating a company's liquidity at a theoretical value of 1. You may use the quick ratio to compare businesses with similar financial profiles or to study a single firm over time.
Quick Ratio Example
The quick ratio is a liquidity indicator in the "Key Ratios" part of quarterly reports for publicly listed corporations. Johnson & Johnson has a quick ratio larger than 1.0, indicating that the company has sufficient liquid assets to meet its short-term debt commitments. In contrast, Procter & Gamble's quick ratio is much below 1, at 0.45, suggesting that the company may not have enough liquid assets to meet its immediate financial commitments.
The Verdict
Cash flow and the capacity to pay invoices when they come due are essential to the survival of any business. A company's ability to quickly liquidate its current assets may be gauged by calculating its quick ratio. The quick ratio is among the most stringent measures of a company's short-term liquidity capability, while it is not the only liquidity ratio used.
