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The quick ratio is a number that tells you within moments whether your company can pay all of its current debts. Also called the acid test ratio, the quick ratio is a measure of your business’s liquidity. The quick ratio formula is relatively uncomplicated. It is:
(Cash & Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities = Quick Ratio
As a conscientious business owner, you already know the importance of business accounting. Your profit and loss statement, balance sheet, and statement of cash flows aren’t just accounting terms—they all work together to tell the story of your business’s finances.
Analyzing your financial statements goes beyond simply looking at the numbers and monitoring whether they increase or decrease, though. There are a number of analytical tools you can use to help you understand your business better. These tools don’t have to be complicated. Simple key performance indicators—KPIs, for short—can help you better understand the story your financial statements are telling.
Many business owners focus on the KPIs specific to their particular industry. Although this is helpful as you measure your business’s success against your competitors’ performance, there are certain KPIs you can monitor without making comparisons to other businesses in your field. Ratios—especially the quick ratio—can give you fast insights into your business’s health and performance, just by using your current financial statements. In this guide, we’ll review what a quick ratio is, go over the quick ratio formula, and explain how you can find the quick ratio for your business.
The quick ratio is a number that tells you within moments whether your company can pay all of its current debts. Also called the acid test ratio, the quick ratio is a measure of your business’s liquidity.
The calculation for the quick ratio focuses on current assets and current liabilities. For the purposes of the quick ratio calculation, current assets are primarily cash and cash equivalents—known as quick assets—as well as some accounts receivable. Basically, anything that can be converted into cash within 90 days or less is considered a quick asset.
Current liabilities—like accounts payable, credit card payments, and loan payments due within the next 12 months—make up the other half of the quick ratio calculation.
For the purposes of the quick ratio calculation, fixed assets like furniture, vehicles, and buildings and long-term liabilities like building loans due more than a year from now are not considered. Equity is also not included in the quick ratio.
The quick ratio is calculated based on information on your company’s balance sheet. The balance sheet is a picture of what your company owns (assets) and what it owes (liabilities.) Unlike the profit and loss statement and statement of cash flows, which only include information for a specified time range, the balance sheet shows your company’s financial position as of a certain point in time.
Assets are shown at the top of your balance sheet, and liabilities are shown below assets. Within each section of the balance sheet, the current numbers appear first.
Inventory, prepaid expenses, and other current assets are excluded from the quick ratio calculation because these assets cannot quickly be converted to cash. Remember, the quick ratio is a measure of cash and cash equivalent assets that can be accessed and used within 90 days. Even though you could conceivably liquidate all or part of your inventory within 90 days, you couldn’t do so without devaluing it with fire sale type discounts.
Inventory, security deposits, and other current assets are included in the current ratio calculation, another ratio commonly used to determine liquidity.
The quick ratio formula is relatively uncomplicated. It is:
There are a few important things to note here, though:
(Current Assets – Inventory – Prepaid Expenses) / Current Liabilities = Quick Ratio
Let’s say you own an independent retail pharmacy. Because you are located in a small town with an aging population, you generously extend credit to your customers. This allows them to get their medications when they need them, and then they pay you when they receive their pension payments.
As of the end of the second quarter, your balance sheet shows the following information:
Which of the items above will be included in the quick ratio calculation? If you said 1, 2, 5, 6, 7, and 8, you’re correct.
The calculation, then, would be:
($250,000 + $36,000 + $8,000) / ($3,000 + $17,000 + $24,000) = Quick Ratio
$294,000 / $44,000 = Quick Ratio
6.7 = Quick Ratio
The quick ratio for your pharmacy is 6.7.
You might be wondering if a quick ratio of 6.7 is good. The simple answer is, “Yes,” but as with most things in accounting, there are exceptions.
Ideally, you want your business to have a quick ratio of at least one. A quick ratio of one means you have on hand just enough cash—or assets that can be easily converted to cash—to pay your liabilities due within the next year. A quick ratio of two would indicate you have twice as much cash, equivalents, and A/R necessary to pay your current liabilities.
From this perspective, the higher the quick ratio, the more liquid the company. How can this be a bad thing?
Although it’s not “bad” to have a very high quick ratio, an abnormally high quick ratio can indicate a business is not using its cash and equivalents very effectively. In the name of financial prudence, a business owner can inadvertently pass up growth or investment opportunities because they are afraid of not having the cash when they need it.
To determine whether or not a company’s quick ratio is “too high,” you must look at the business’s complete financial picture. Perform the quick ratio calculation as of several points in time. If it is consistently abnormally high, consider whether the business might make more effective use of its cash.
Let’s look at another example. Your marketing firm’s balance sheet shows the following information as of the end of the second quarter:
Your quick ratio calculation is:
($10,000 + ($25,000 – $13,000)) / $30,000 = Quick Ratio
$22,000 / $30,000 = Quick Ratio
0.73 = Quick Ratio
The quick ratio for your marketing firm is less than one. What does this mean?
First of all, don’t panic. There are a number of reasons why a financially healthy company could have a quick ratio of less than one. Depending on the date of the analysis and how it compares to your company’s cash conversion cycle, you could have a quick ratio of less than one on Monday and by Friday have a quick ratio of two or higher.
As is the case for a business with a very high quick ratio, It’s important to monitor your quick ratio over time and consider all aspects of your business before determining whether your quick ratio warrants concern.
Knowing your quick ratio can allow you to easily see if your current liabilities are outstripping your ability to repay them quickly, but is the quick ratio something others are concerned with?
As you might have guessed, both lenders and investors often use the quick ratio to make decisions about whether to loan your business money or invest in it. Lenders want to know they will be able to collect on the money they lend your business (plus interest). Similarly, investors want a reasonable assurance they will receive dividends from their investment.
There are a number of financial metrics you can use to analyze your business. The quick ratio is a fast and uncomplicated calculation, which gives you powerful insights about the health of your company. By taking a relatively quick look at your business’s balance sheet and performing a simple division operation, you can easily tell if your business is able to pay back its obligations or if you might be headed for trouble.
Although a quick ratio of one or higher is desirable, you shouldn’t panic if your quick ratio is less than one. You also shouldn’t become too complacent if your quick ratio is two or higher. It’s important to take all factors of your business into consideration before determining if your quick ratio is too low, too high, or just right.
This is where your accountant or bookkeeper can be a very helpful sounding board. These financial professionals know your business almost as well as you do, and they will be able to provide clarity about what your quick ratio number—and other metrics in your business—are telling you.