One helpful ratio for business financial health check, is the Quick Ratio formula – it is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets. (Usually within 3 months or less).
By indicating the company’s ability to instantly use its near-cash assets (that is, assets that can be converted quickly to cash) to pay down its current liabilities, it is also called the acid test (a quick test result, an old expression from using acid to test metals).
Quick Ratio (QR) = Current Assets less Inventory / Current Liabilities
A store has –
- Cash $2,000
- Accounts Receivable (Lay-by) $3,000
- Inventory $12,000 (not used)
- Current Liabilities $3,500
- QR – (2,000 + 3,000) / $3,500 = 1.43 (quick assets are 1.43 times current liabilities)
The QR formula uses current assets that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets.
Short-term investments or marketable securities include trading securities and available for sale securities that can easily be converted into cash within the next 90 days.
The Quick Ratio shows us how well a company can cover it current liabilities. If a firm has enough quick assets to cover its total current liabilities, the firm will be able to pay off its obligations without having to sell off any long-term or capital assets.
Since most businesses use their long-term assets to generate revenues, selling off these capital assets will not only hurt the company it will also show investors that current operations aren’t making enough profits to pay off current liabilities.
A company with a quick ratio of 1 indicates that quick assets equal current assets. This also shows that the company could pay off its current liabilities without selling any long-term assets. An acid ratio of 2 shows that the company has twice as many quick assets than current liabilities.
Higher quick ratios are more favourable for companies because it shows there are more quick assets than current liabilities.
The Current Ratio includes the inventory, so it is similar to the Quick Ratio.
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