There are many ratios for interpreting the data in financial statements. One of the most essential of these is the quick ratio. When used correctly, this can provide insights into a company’s short-term liquidity, so it is essential for evaluating the financial health of a business.
In this post, we will look at the concept of the quick ratio and its role in determining a business’ ability to meet its short-term obligations. Let’s take a closer look.
What is the quick ratio?
Another common name for the quick ratio is the ‘acid test ratio’. Essentially, it is a liquidity metric that can be used to measure an organisation’s capacity to meet its short-term obligations. It is based around liquid assets, meaning those that can be quickly converted into cash.
For example, consider a local butcher’s shop that is suddenly in need to urgently repay a debt. Their most liquid assets are resources they can use quickly to make that payment. This could mean cash in the register or the freshly cut meat they can sell in a single day. However, the things they store in the back, like seasonings or other such things, are less liquid, despite being necessary to operate the business.
This is the foundation of the quick ratio. It revolves around things that can be easily liquidated and ignores anything that would take longer to liquidate. As such, it is a reliable measure of a business’ ability to meet its debts without having to sell inventory. It is a stripped-down, brutally honest snapshot of financial health.
What are the components of the quick ratio formula?
There is a formula to calculate the quick ratio:
QUICK RATIO = (Current Assets – Inventory) ÷ Current Liabilities
So let’s break this down into its component parts:
- Current Assets: Assets that you can convert into cash within 12 months, including cash, accounts receivable, marketable securities, etc.
- Inventory: Goods that you are yet to sell. They are counted as a current asset, but may not be converted into cash quickly.
- Current Liabilities: The obligations you have to pay within a year, including salaries payable, accounts payable, short-term debt, etc.
Every component is crucial in determining the quick ratio. In turn, this offers insights into the liquidity status of an organisation.
How is the quick ratio calculated?
With a good understanding of the components of the formula, calculating the quick ratio is actually quite straightforward.
- Subtract the value of the company’s inventory from that of its current assets. This leaves you with the value of the company’s most liquid assets.
- Divide this number by the value of the organisation’s current liabilities.
Let’s imagine a company has current assets of £300,000, and inventory of £50,000 and current liabilities of £100,000. The calculation for the quick ratio would look like this:
(300,000 – 50,000) ÷ 100,000 = 2.5
So what does the quick ratio mean?
A quick ratio of 2.5, like the one calculated above, indicates that the organisation has 2.5x the amount of easily liquidated assets as the value of its short-term liabilities. This means the organisation is in a position to pay off its short-term liabilities and still have more than an equal amount of its most liquid assets remaining.
Interpreting this quick ratio can indicate a company’s financial stability. Any quick ratio higher than 1 is generally perceived as an indicator of good financial health. However, context is important, and you should look at industry standards of quick ratios to get a better idea of the health of your company. In some cases, a high quick ratio could even indicate that you are struggling to sell your products.
What is a good quick ratio to have?
The definition of ‘good’ for quick ratios is quite subjective. It depends on the industry standards and your company’s specific circumstances. Generally speaking, 1,0 is considered a good quick ratio, because its most liquid assets could cover its short-term liabilities. Just bear in mind that context matters.
What’s the difference between current ratio and quick ratio?
Another frequently-used measure of liquidity is the current ratio. This is calculated as:
Current Assets ÷ Current Liabilities
Unlike the quick ratio, it takes all current assets into account, so its view is a little more lenient. This means that a company can have a high current ratio but a low quick ratio. Both are important for measuring a company’s ability to meet its short-term liabilities, but their perspectives are different. Having a sizable inventory doesn’t necessarily mean those assets could be swiftly monetised.
To get an accurate view of a company’s liquidity, it is important to understand both types of ratios and the unique perspectives they offer. This could provide a more holistic picture of short-term financial health.
Is the quick ratio helpful in practical business scenarios?
Ratios are invaluable for their practical insights. They can help creditors assess the financial state of a company, or assist prospective investors in assessing financial health. It can even inform internal decision-making processes.
Company executives can use the quick ratio to make informed decisions about future expenditure or identify areas for improvement. The values you need (current assets, current liability and inventory) can all be found on the company balance sheet, so it is not difficult to make a swift calculation of the quick ratio.
The role of the quick ratio in analysing financials
For investors, creditors and company executives alike, an understanding of the quick ratio can provide valuable insights into short-term financial health of an organisation. This guide has given you everything you need to know to use the quick ratio as a tool in making financial decisions.
Remember that ratios do provide valuable insights, but they are not comprehensive. You must use them in conjunction with other tools of financial analysis alongside industry knowledge. This way, you get a holistic perspective of the financial performance of an organisation. Doing this work is the best way to get a broader picture of how well a business is doing.
How can ERP help businesses calculate their quick ratio?
For a quick ratio to be accurate, it relies on accurate numbers being used in its calculation. This can be difficult for businesses who don’t have accurate visibility of their current assets, current liabilities and current inventory.
ERP software gives businesses a way to manage these things centrally, from one database which gives a true and accurate picture of the businesses current standing. This means businesses using ERP can calculate financial ratios such as quick ratio more accurately and more quickly.
Why choose Eventura as your ERP implementation partner?
Eventura has been providing robust business solutions to countless organizations for over two decades. We are ERP experts and can identify all of your business needs, and deliver a comprehensive ERP solution that works for you.
As Sage 200 Partners and NetSuite Solution Providers, we can help you identify which solution will fit your business needs the best. Our expert team of business analysts, developers, consultants, technicians and support staff can guide you through your entire project, from initial scoping through to implementation and on-going support.
We’re also managed IT service providers meaning we can help you identify your entire IT infrastructure requirements from day one. If you would like to speak to one of our ERP experts, you can request a free call back here.
