The Quick Ratio, also known as an Acid-test, is a measure of liquidity. But what exactly is the Quick Ratio, how is it calculated, and how is it used in business?
Let’s find out!
The Quick ratio, also known as the Acid test or Liquidity ratio helps a business assess if it is able to pay its short-term liabilities. It is called Quick-Ratio because it measures a business's ability to use its available cash or “quick assets” to immediately pay off its current liabilities - debts owed within 12 months.
Unlike the Current Ratio, the quick ratio does not take into account a business’ inventory. It is therefore most useful for companies that typically have a lower stock turnover such as high-end goods, car dealers & appliance stores - to name a few!
“If you’re putting a soccer team together among all assets, stocks get picked last. Compared to receivables or bank balance, it’s slower to convert into cash. This ratio focuses on the company's ability to mobilize short-term assets.”
The quick-Ratio is very useful to monitor your business performance. It’s also an important metric for banks and investors!
If your ratio is below 1, your company is likely to meet financial trouble in the near future, as you might not be able to pay your current liabilities, putting your business at risk!
If your Quick ratio is high, your business has a lot of liquid assets. This can help back-up potential investment as liquidities allow you to meet your obligations.
“Take it with a pinch of salt depending on how heavy your stocks are in your current assets! A ratio of less than 1 is not always a bad sign, the number will have to be put into perspective!”
A word of warning - having a high Quick Ratio can be a sign of poor liquidity management. If you have a lot of available cash or “quick assets” it’s likely that you could be putting it to better work and using it to grow your company through investments.
Lets now see how to calculate the Quick Ratio!
It’s simple. To calculating the Quick Ratio you compare your current assets with your current liabilities, excluding inventory.
Current assets are your bank balances, the accounts receivable (the cash you are still owed), and your liquid assets (available cash).
Current liabilities are the obligations you are supposed to pay within a year. These include bank loans, accounts payable, wages, lease payments, and income taxes payable.
The formula is as follows:
CURRENT ASSETS - INVENTORIES ÷ CURRENT LIABILITIES
Example : Your current assets sum up to €5000, your inventories to €1500 and your current liabilities amount to €2000.
€5000 - €1500 ÷ €2000 = 1.75
“Having a quick ratio close to 1 for companies with heavy stocks is nothing short of a miracle story you could see on telly! But depending on your industry, the impact of stocks will be more or less important. The figure will only make sense when compared to the average ratio of companies in the same sector!”
As with many business performance metrics, knowing and monitoring your Quick Ratio allows you to do several things :
Remember: the Quick Ratio is different from the Current Ratio. While they are both liquidity ratios, the quick ratio does not account for stock/inventory. It therefore produces a more conservative assessment of your business's liquidity position. Whether you use one or the other relies on the nature of your business. The amount of stock obviously weighs heavily in the difference between the two metrics.
“It is difficult to make sense out of it without comparing it to others. Unlike the current ratio which can be interpreted in absolute terms.”
It is the little brother of the current ratio, it is the same formula except for one detail, we remove the value of stocks from current assets!
If you’re putting a soccer team together among all assets, stocks get picked last. Compared to receivables or your bank balance, it’s slower to convert into cash. Hence their exclusion from the formula, as this ratio focuses on the company's ability to mobilize short-term assets.
Ratio to be used with a pinch of salt depending on how heavy your stocks are in your current assets! A ratio of less than 1 is not always a bad sign, the number will have to be put into perspective!
If the current ratio makes you scared, avoid the quick ratio; it may be even scarier. So let's not stress too much, ok?
In the first few months, when purchases increase to build up inventory for the upcoming production launch, it is possible that most of the company's current assets are made of inventory...I let you imagine the amount of current assets if we subtract the value of… stocks.
For companies already at cruise speed, the quick ratio can be a good indicator to see how strong their back is!
Having a quick ratio close to 1 for companies with heavy stocks is nothing short of a miracle story you could see on telly! But depending on your industry, the impact of stocks will be more or less important. The figure will only make sense when compared to the average ratio of companies in the same sector!
For a company that has zero stock, like those intellectual services, the quick ratio will be equal to the current ratio! Therefore, it’s especially interesting for companies with large inventory levels - such as supermarkets for instance.
It is difficult to make sense out of your quick ratio without comparing it to others. Unlike the current ratio which can be interpreted in absolute terms.
But do not panic! Given the liquid nature of stocks, the quick ratio is more of an indicator with a scary name than an indicator you HAVE to rely on in the daily financial management of your company.
The liquidity of your business is important. It should be monitored and exploited at its best! The best way to do so is having reliable, real-time and 24/7 access to your cash flow data. Trezy automates all those boring processes! Saving you time and erasing the risk of spreadsheet mistakes!
As we saw, only calculating your Quick Ratio is useful, but there are so many more metrics to track in order to run a successful business! Your financial management deserves a tool that can compile, classify and put in perspective every incoming or outgoing transaction - in order to gain the clearest insights.
With Trezy, you can keep track of your liquidity position and make the best decisions for your business.
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