Need to know how your business would be able to handle a sudden liquidity issue? Learning how to calculate the quick ratio could be a great move. But what is the quick ratio? Find out more about the quick ratio / acid test ratio with our comprehensive guide.
Quick ratio formula explained
So, what is the quick ratio? The quick ratio, which is also known as the acid test ratio, is a liquidity ratio that measures the ability of businesses to pay their current liabilities with quick assets. It’s a great indicator of short-term liquidity, giving you an excellent insight into how your business would fare if it became necessary to quickly convert assets to pay for liabilities.
But what are quick assets? Essentially, quick assets are current assets that could be converted to cash within 90 days or so. Marketable securities, cash equivalents, accounts receivable, and short-term investments are all considered to be quick assets.
Put simply, the quick/acid test ratio measures the dollar amount of liquid assets against the dollar amount of current liabilities.
How to calculate quick ratio
You can learn how to calculate the quick ratio by adding up all your company’s quick assets and dividing by current liabilities. As a result, the quick ratio formula reads as follows:
Quick Ratio = Cash + Cash Equivalents + Marketable Securities + Accounts Receivable
You should be able to find all these components on your company’s balance sheet, but it’s important to double-check when you’re entering them into the formula. Only accounts receivable that can be collected within 90 days should be included. If you have accounts receivable that it’s not possible to collect within 90 days, ensure that these aren’t counted, or it could skew your result.
Let’s look at an example to see how this works in practice. Imagine Company A’s balance sheet reads as follows:
Cash and cash equivalents – $20,000
Short-term investments – $10,000
Receivables – $25,000
Current liabilities – $50,000
You could work out the quick/acid test ratio like this:
(20,000 + 10,000 + 25,000) / 50,000 = 1.1
This means that Company A can pay off all their current liabilities with their quick assets, and still have a small amount left over.
What is a good quick ratio / acid test ratio?
Quick ratio / acid test ratio should always be analyzed alongside other liquidity ratios, such as current ratio or cash ratio.
It’s also important to contextualize your business’s quick ratio by looking at the industry within which your company operates. If your business has a lower quick ratio than the industry average, it could indicate that it may have difficulty honoring its current debt obligations.
However, a quick ratio that’s much higher than the industry average isn’t necessarily a sign of financial health, as it could indicate that the company has invested too heavily in low-return assets.
Difference between current ratio and quick ratio
Although current ratio and quick ratio both measure a company’s short-term liquidity, they do have several key differences that you should be aware of.
Put simply, the quick ratio formula is more stringent than the current ratio, as the current ratio includes more items in its calculations (such as inventory and prepaid expenses).
In short, the difference between current ratio and quick ratio is that quick ratio focuses on more liquid assets, rather than current assets that it may not be able to liquidate as quickly.
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