The quick ratio, also known as the acid ratio, is one the most important metrics of a firm’s short-term liquidity. The ratio estimates if a company can effectively meet its short-term financial obligations by using its quick assets, i.e. assets that can be quickly converted into cash, such as marketable securities and short-term investments.
Financial analysts use quick ratio analysis to compare companies that operate in the same industry or sector and determine their financial health. In addition, quick ratio provides an indication of how much of its debt a firm can cover by selling its liquid assets in less than 90 days.
How does it work
In its simplest form, the quick ratio excludes inventories and estimates a firm’s short-term liquidity as:
(Current Assets – Inventories) / Current Liabilities
In a more elaborate form, you may encounter it as:
Ideally, the quick ratio should be equal to 1, suggesting that the company can meet its short-term obligations with its current assets.
If the quick ratio is > 1, you should look at the cash that the firm has on hand or at the average collection period of accounts receivable. If the quick ratio is < 1, you should look at the firm’s inventory levels. As inventory is hardly a liquid asset, perhaps the company relies too much on inventory to pay its short-term liabilities.
Assuming that you want to perform a quick ratio analysis on the following balance sheet:
04.30.2016: Current assets – inventories = 60,108.16 – 44,513.78 = 15,594.38. Hence, the quick ratio is 15,594.38 / 70,284.52 = 0.2201.31.2016: Current assets – inventories = 63,424.89 – 44,468.65 = 18.956.24. Hence, the quick ratio is 18,956.24 / 64,607.66 = 0.29
07.31.2016: Current assets – inventories = 59,778.34 – 43,453.87 = 16,324.47 Hence, the quick ratio is 16,324.47 / 68,155.27 = 0.24
10.31.2016: Current assets – inventories = 65,755.15 – 49,822.65 = 15,932.50. Hence, the quick ratio is 15,932.50 / 74,134.74 = 0.21
So, you see that the firm’s quick ratio decreased by 26.8% throughout 2016. Why this happened?
- Current liabilities increased 14.7% from 64,607.66 in 01.31 to 74,134.74 in 10.31.
- Inventories increased 12% from 44,468.65 in 01.31 to 49,822.65 in 10.31.
- Yet, the increase in current assets is only 3.7% from 63,424.89 in 01.31 to 65,755.15 in 10.31.
The inventory levels are high relative to the firm’s current assets. This justifies a quick ratio lower than 1 throughout the year. Also:
- Accounts receivable decreased by 5.0% from 5,624.00 in 01.31 to 5,344.00 in 10.31, suggesting that the firm collects its bills rather slowly.
- Accounts payable increased 11.7% from 38,475.61 in 01.31 to 42,991.25 in 10.31, suggesting that the firm is paying its bills too quickly.
This is how a quick ratio analysis works.
The quick ratio is a valuable tool in financial statement analysis but like most metrics, it comes with potential drawbacks. Although the ratio estimates a firm’s liquidity taking into account its current assets and current liabilities, it does not provide any indication about the company’s cash flows, which enable the firm to meet its current obligations when they are due.
In fact, the ratio assumes that that accounts receivable are collected immediately, which may not be true for many companies. So, to be on the safe side, one should also look into the firm’s cash flow statement to see the level of operating cash flows and how they change over time.
Also, quick ratio assumes that the company will liquidate its current assets, which may not be possible for many companies. In this case, the working capital is important (current assets – current liabilities).
Quick ratio as an indicator of bankruptcy
Generally, a low quick ratio is not a good indicator, and sometimes, even a quick ratio close to 1 may not give a clear picture of a company’s financial health. The once leading retailer Borders went bankrupt in 2011, failing to keep up with the evolving technology of e-books and online presence. But another factor was also high leverage.
Let’s have a look at the company’s balance sheet from 2007 to 2011:
The calculations for quick ratio produce the following table:
The quick ratio decreased 20.4% from 2007 to 2011 due to decreasing inventories (-52.6%), accounts receivable (-57.0%), and current assets (-58.3%). Accounts payable decreased by 38.6% and current liabilities decreased by 47.6%. Notice that in 2009 current assets decreased 28.9% and in 2010 accounts receivable decreased by 35.4%. Although the quick ratio is slightly above 1 in both years, you should look into the company’s balance sheet to assess its solvency and financial health.