Overview of Quick Ratio / Acid Test Ratio
Acid test ratio, used today is defined as quick ratio. This short-term solvency of a firm is measured here.
This formula measures how accurately an organization’s short-term obligation can be repaid with short-term current liquid assets except that of inventory items.
It is the quick ratio, also called the fast ratio. This test is more rigid compared to the current ratio, which considers all those assets which would take time to sell in the market.
Formula for Quick Ratio
The formula for calculating the Quick Ratio is: Quick Assets / Current Liabilities
- Quick Assets: Those assets that can be simply used in meeting cash necessities include cash and cash equivalent, marketable securities and accounts receivable.
- Current Liabilities: Current liabilities that is; those to be remunerated within the current financial year such as; accounts payable, short-term borrowings, and other or current liabilities.
Example Calculation
Scenario:
A company has the following balance sheet details:
- Cash: $50,000
- Marketable Securities: $30,000
- Accounts Receivable: $70,000
- Inventory: $40,000
- Prepaid Expenses: $10,000
- Current Liabilities: $100,000
Step-by-Step Calculation
- Calculate Quick Assets
- Apply the formula: Quick Assets / Current Liabilities
Interpretation:
- A quick ratio of 1.0 shows that the company will be in a position to offset its current liabilities with a hundred per cent of the most liquid of the assets.
Pros of the Quick Ratio
- Stricter Liquidity Measure: Excepting inventory that can may not be easily liquidated, giving a more accurate report of the company’s assets when it comes to liquidity.
- Helps in Risk Assessment: Helpful for creditors and investors in analyzing the solidity of a particular company especially in business that experience changes in inventory prices.
- Encourages Better Cash Management: Relies with organizations to ensure that they work hard to achieve their current assets as they are over committed to ensure that all their current obligations are met.
- Industry Comparisons: Provides a benchmarking tool to assess the relative liquidity between separate companies within the same sector.
Cons of the Quick Ratio
- Ignores Inventory Utilization: It was developed bearing in mind certain limitations which might render it unsuitable for industries which have inventory as a major part of current assets like retail or manufacturing.
- No Context for Liquidity Sources: Lacks timing of inflows and outflows, which distorts period results.
- Static Measure: Taking into consideration the balance sheet values implying that the given data do not necessarily indicate how much cash and cash equivalents company possesses at the precise date of analysis.
- Overlooks Quality of Receivables: Consequently, it has the tendency of assuming that all the accounts that reflect in the company balance sheet as accounts receivables are realizable, which may not be the case.
Uses Of Quick Ratio
- Creditworthiness Evaluation: The quick ratio is valuable because it shows how well a company can cover the short-term liabilities of balances within the short term, according to the lenders.
- Investment Analysis: A shareholder uses the ratio with the aim of judging the financial strength of an investment opportunity.
- Internal Financial Management: Evaluating quick ratio helps companies ensure that it has enough liquidity to efficiently run its business.
- Industry-Specific Use: Most suitable for organizations within the service sector who rely on a low turnover of stock.
Quick Ratio vs. Current Ratio
The current ratio encompasses inventory and prepaid expenses, thus being another measure that more widely demonstrates the company’s solvency.
On the other hand, reliability is narrowed down to very liquid assets only, which makes the quick ratio even more desirable by some.
This difference is particularly important in industries where replenishment of inventory occurs less frequently as this would indicate a higher current ratio than is actually healthy for the firm.
Real-World Example
Company A vs. Company B
Company A:
- Quick Assets: $150,000
- Current Liabilities: $120,000
- Quick Ratio: 1.25
Company B:
- Quick Assets: $80,000
- Current Liabilities: $100,000
- Quick Ratio: 0.8
Interpretation:
- Overall Company A is in better liquidity position as it means that the firm is in a better position to pay its current liabilities than company B.
Advantages of a High Quick Ratio
- Financial Stability: It suggests a better position to meet the current obligation.
- Attracts Investors: Illustrates how cash and receivables should be managed most efficiently.
- Improves Credit Ratings: This should help demonstrate low liquidity risk to creditors and rating agencies who frown upon companies with a high level of already leveraged sales, that is, accounts receivables.
Disadvantages of a High Quick Ratio
- Underutilized Resources: Therefore, excess of codes 1 and 2 may imply inefficient utilization of the available resources in the firm.
- Potential Overcapitalization: Can lead to recommending a passive strategy that might restrain the business development.
Ways to increase quick ratio
- Optimize Receivables Collection: Decrease the cycle to receive payments from customers.
- Manage Short-Term Liabilities: Offer to buy more merchandise to be paid for in a long time.
- Increase Liquid Assets: Cultivate a good position in cash and marketable securities.
Quick Ratio in Excel
Example:
Suppose you have the following data:
- Cash: $40,000
- Marketable Securities: $20,000
- Accounts Receivable: $50,000
- Inventory: $30,000
- Prepaid Expenses: $10,000
- Current Liabilities: $100,000
Steps in Excel:
- Input data into cells (e.g., A1: For the names of assets and liabilities, use A6 while for their respective values, use B1:B6.
- Use the formula:
- Apply the Quick Ratio formula:
- Result: The quick ratio that has been calculated will be displayed in the particular cell.
Conclusion
Quick Ratio is an important measure good for evaluation of firm solvency in the short term. Barren though it provides the most rigid view of liquidity, it is utilizable alongside other financial measures for the best results.
Recognizing the virtues and demerits of quick ratio, and its usage enables decision makers to make right decisions.
Frequently Asked Questions
1.Can High Quick Ratio Be Bad?
Yes, a very high Quick Ratio may indicate that the company is not using its assets effectively or just stockpiling too much cash.
2. How to improve Quick Ratio of a company?
Through increase in liquid assets, reduction in short-term liabilities, or better collection of accounts receivable.
3. Is the Quick Ratio relevant to a startup?
Yes, especially in startups that are required to illustrate their financial fitness to investors or lenders. But again, relevance depends on business models and the industry.
4. What is Good Quick Ratio?
1:1 and above is generally considered healthy in that it gives the impression of short-term liability coverage by highly liquid assets
5. How does this Quick Ratio relate to the Current Ratio?
If the Current Ratio were to represent all current assets, the Quick Ratio would not. It would only contain net accounts receivables, prepayments, etc,and exclude those items which will take time, such as accounts receivable including inventory and prepayments.
6. What Industries Would More Likely Use the Quick Ratio?
This ratio will be used in businesses whose inventories fluctuate, such as retail or manufacturing, to further review liquidity better.
7. What Are the Weaknesses of the Quick Ratio?
It does not consider the cash flow timing neither the real liquidity of some assets, which are recognized as current