What is an ideal quick ratio? How is it different from the current ratio?

What is the Meaning of a Quick Ratio

The quick ratio indicates a company’s short-term liquidity position of an enterprise. It measures its ability to meet short-term obligations through its topmost liquid assets. The Quick Ratio is also termed as the Acid-test ratio or the liquidity ratio for its ability to identify the quick-cash assets that can easily pay off the short-term liabilities of a business. This implies what may be a company’s position to convert an asset into cash. These assets are generally hard cash, marketable securities, and accounts receivable or debtors. These assets are therefore known as “quick” assets as for their ability to be quickly converted into cash.

What is the Need for a Quick Ratio?

The quick ratio acts as the barometer of a company’s capabilities to pay off its short-term obligations. The interested parties to this fundamental are Investors, suppliers, lenders etc. who are more than eager to understand if a business is viable to have sufficient  cash or cash equivalents  to pay their money that they have invested in the business. 

Also, in terms of identifying prospective investors, it shows well on a business to have a well-defined liquidity ratio. This signals competency and is an indicator of a sound business performance that may eventually lead to a sustainable growth.

As for internal business matters, a quick ratio takes into account the most liquid assets that a company can easily convert into cash to pay off their bills swiftly. Thus acting as a major contributing tool for decision-making. 

Reasons for the need of a quick ratio:

• Quick ratio gives a more suitable profile to the company’s liquidity position as it eliminates the closing stock from the calculation. Evaluating the closing stock can be a sensitive issue as it may not always be at its retail value. Hence,  we can conclude that the quick ratio is not impaired.
• In a sinking industry, the ratio shall help to provide the company with a significant authentic repayment ability as against the current ratio that includes the closing stock.
• By using the quick ratio, the true liquidity position can be tackled. Additionally, it shall limit the companies from getting additional loans. Now because of the high inventory base, it is likely that a company may overstate the short-term financial strength of if the current ratio is taken into order and hence deviate the interested parties.

How to Calculate the Quick Ratio?

Quick Ratio = [Cash & equivalents + marketable securities + accounts receivable] / Current liabilities

Or

Quick Ratio = [Current Assets – Inventory – Prepaid expenses] / Current Liabilities

For example, let’s assume a company X has:

Cash: $100 Million

Marketable Securities: $200 Million

Accounts Receivable: $250 Million

Accounts Payable: $100 Million

This company shall account for a liquidity ratio of about 5.5, which means that it can pay its current liabilities 5.5 times by overusing the utmost liquid assets. A quick ratio of above 1 is an indicator that a business has sufficient amount of cash or cash equivalents to pay off its short-term financial obligations and shall be able to sustain its working operations.

Difference Between A Quick Ratio And A Current Ratio.

The quick ratio is known to be more conservative than that of the current ratio. This is because in  most of the companies, inventories are supposed to take time to liquidate, which is why they are not considered while calculating a quick ratio. Also, prepaid expenses, even though they are an asset, cannot be used to pay off the current liabilities, hence they're deducted from the assets  quick ratio but current ratio on the other hand, takes into account both prepaid expenses and stock, which may be viable for some companies but not all. Let us understand the core difference with the help of a table 

Conclusion:

As for Companies, they must focus on maintaining this ratio at an adequate leverage so as against the liquidity risk. 

Well it is said that the highly uncertain the business environment, it is more  likely that companies would be able to keep higher quick ratios. In contrast, companies with constant cash flows may fall on to maintain relatively lower levels of the quick ratio. Therefore it is vital that a company  must strive to attain a correct balance between  the liquidity risk occurring by a low ratio and the risk of loss occurring due to a high ratio. 

Also, for an investor it is important to note that if the acid test ratio is higher than that of  the industry’s  average then  the company is certain to be investing too many resources in its business working capital, which may decrease its sustained profits and thus bad news for the investors. Also, the ratio, which appears to be lower than the industry average, may be a signal that the company is at high risk by not maintaining a legitimate shield of liquid resources.