What is Quick Ratio? Meaning, Formula & Calculator

Do you wish to calculate the Quick Ratio of a business? Don't miss out our Quick Ratio Calculator that's free to use and embed too! But before that, also learn in detail about Quick Ratio, its formula, how it is calculated and much more.

Ratios can make life simpler. But improper understanding of them can also often make investment complicated, the idea is to not look at ratios as absolute, but inter-twined with company’s operations. One of the ratios often used to check liquidity is called quick ratio. Let’s get into it!

What is a Quick Ratio?

Quick ratio is one of the liquidity ratios, loosely defined quick ratio tells you about the liquidity position of a company, more importantly a company’s ability to pay short term obligations.

Here’s the thing. Among ratios, liquidity ratios are the real deal. In a very straight-forward manner, liquidity ratios basically tell you whether a company is in a position to survive the next 12 months. This is particularly useful, for both long term and short term investors, because of a very famous phrase in finance, ‘Return of capital is more important than return on capital.’

A quick ratio basically measures a company’s ability to pay its short term liability obligations that are liability obligations due in the next 1 year without having an impact on the market price of its asset. The last part is very important; because the idea is that the company should be able to meet its short term expectations without having an impact on its market reputation.

What's the Quick Ratio Formula?

Here’s the Quick ratio formula, that you can grasp quickly:

Quick Ratio = (Current Assets* – Current Inventory)/ Current Liabilities

or

Quick Ratio = Current Assets* – Inventories – Prepaid Expenses / Current Liabilities

If you understand Balance Sheets, you know that there is an alternative formula to do this, sort of like holding the ear with the other hand.

Quick Ratio = Capital Employed + Marketable Securities  + Accounts receivable / Current Liabilities

Current assets* include cash on hand, accounts receivable, any shares, bonds, etc held as an investment.

But you could have read that in a textbook, lets understand the rationale of it.

Quick Ratio: What's the Logic behind it?

First of all, quick ratio is very similar to current ratio, which is basically all the current assets divided by current liabilities. But a quick ratio displays the liquidity better, for reasons we’ll get into. It is also why it is called the ‘Acid-test’ ratio.

A Quick ratio doesn’t include inventories as a current asset, which includes both finished goods and semi-finished goods. Here’s the logic. You see current assets are those assets that could be converted into cash within 90 days. If a company were to do that with its inventories, the supply shock would in essence kill the demand, lowering both price and market reputation of the company.

The second thing Quick Ratio doesn’t include is prepaid expenses. To understand that, you need to know the very subtle difference between things that have cash value and things converted to cash. You see prepaid expenses do have cash value, for example prepaid expense for advertisement that would be going on for five years. All of the expense would be done in the first year, but it would have a cash value providing benefit over five years, hence it is an asset accruing benefit over five years. But you can’t exactly sell that, get it?

Also, current liabilities are liabilities that to have to be paid within next one year, including but not limited to accounts payable, short term debt, accrued wages and so on.

How is Quick Ratio Calculated? Example

Let’s understand this with an example. Consider the following information.

A company Lethal Weapon ltd. has following balances:

Cash and Cash Equivalents = Rs. 1,00,000

Shares of Scarface Ltd. (Temporary Investment) = Rs. 1,00,000

Trade Receivables = Rs. 50,000

Wages Payable = Rs. 70,000

Trade Payables = Rs. 1,20,000

Income Taxes Payable = Rs. 60,000

Quick Ratio = 100000 + 100000 + 50000 / 70000 + 120000 + 60000

= 350000 / 350000

= 1

Interpreting this, the company Lethal Weapon ltd. as many current assets as it has liability obligations coming up, which means worst case scenario, the company might be able to meet its short term debt obligations with ease.

This is also one of the reasons why ideal quick ratio is considered 1.

And yes, no matter in whatever currency you wish to get the results, the Quick ratio formula remains same.

How do Customers & Type of business Impact a Company’s Quick Ratio?

Here, we jump on to a little more analytical part. The thing is, while assets and liabilities are numbers on a sheet, they, in essence represent actions of people.

Now, what this means?

Suppose, you take accounts receivable as a company’s current asset in calculation of quick ratio, and you get a particular answer. You are right both mathematically and formulaic-ally, but you can still be wrong in your judgement of using this. Here’s how?

Maybe the company failed to recover those amounts from its customers, which could be for a ton of different reasons. Now this may have a cascading effect on company’s short term liquidity, and maybe it may so happen that because customers didn’t pay, the company doesn’t necessarily have money to pay its suppliers, which halts or decreases production, creating a chain of events that numbers couldn’t have possibly displayed. Well, not just quick ratio, at least.

Financial Ratios: Significance

What’s the lesson here? Don’t think of ratios in individual absolute, but keep in mind the inter connectivity of actions.

See if a company’s Current Ratio is 2 but the Quick Ratio is 1, it means the company has inventories as much as its current liabilities, increasing inventory costs, which may depend industry-wise whether it is good or not. In the aforementioned example, one may look at account receivable cycles and duration of the company to get better idea of the company’s holding.