We perform a liquidity ratio analysis to evaluate the ability of the company to settle its obligations on time. The most common use case is when lenders and creditors want to gain a better understanding of the financial health of a borrower or customer. Analysts use the gained insights to set credit terms and manage risk appropriately.
The Quick Ratio is a liquidity measure for the ability of the business to cover its current obligations when they become due, using only the most liquid assets (also known as quick assets).
We also refer to the Quick Ratio as the Acid Test. This is a reference to early miners who used acid to test metals for gold. Base metals of no value corroded under the acid test and were of no interest.
The Quick Ratio shows us the efficiency with which a company can meet its short-term liabilities. It’s a more conservative version of another liquidity ratio, the Current Ratio.
The Quick Ratio provides us with a more rigorous assessment of a firm’s ability to pay its current obligations. It does so by only leaving the most liquid assets in the calculation. We use the Quick Ratio mainly to evaluate the ability of the company to pay its current liabilities without the sale of inventory. It is also a good liquidity measure for when companies have slow-moving or obsolete inventory or find it hard to sell their goods and raw materials.
Inventory is the most obvious one to exclude, as it is not so easily convertible to cash. Also, when companies sell inventory in stressful situations, it is usually at a discount, which brings its Net Realizable Value down. However, for businesses with high inventory turnover, like Fast-moving Consumer Goods (FMCG) enterprises, we might consider the goods as a quick asset and include them in the Quick Ratio calculation.
We also exclude prepaid expenses as we cannot use them to pay other liabilities.
A ratio of above one means the company can currently cover its short-term obligations with its most liquid assets. On the other hand, if the Quick Ratio falls below one, this means the business cannot currently fully settle its short-term liabilities.
Current assets that we can generally convert into cash within 90 days are considered most liquid (quick). The most common categories of assets that fall within the definition include:
- Cash and cash equivalents;
- Short-term investments;
- Marketable securities;
- Trade receivables;
- Other receivables, excluding prepaid expenses and advances.
Calculating the Quick Ratio
The Quick Ratio takes information from the Balance Sheet of the company and we figure it via the following formula:
In some cases, published financial statements do not include a break-down of quick assets. In these circumstances, we can approach the calculation differently.
Quick Ratio Analysis
If the quick assets are enough for the company to cover its current liabilities, the business can cover its obligations without the need to liquidate any long-term assets and investments, or increasing its debt financing. Such actions would usually be a clear signal to investors and lenders that the current operations are not performing sufficiently to cover the current obligations as they arise.
We prefer a higher Quick Ratio, as it represents better liquidity. A commonly accepted rule of thumb is to consider the ratio as a good one if it is above one. A higher ratio indicates that the company is financially stable in the short-term. This is a good sign for investors, as it means the business is performing well operationally. But it’s an even better sign for creditors, as they want their balances to be promptly recoverable.
A declining or low (usually below 1) Quick Ratio can indicate a few things for the company:
- It’s struggling to grow or even keep sales revenue at the same levels;
- The company is over-leveraged;
- The business is paying obligations to vendors too fast, or is unable to negotiate beneficial credit terms;
- Accounts receivable collection is too slow, or the company has uncollectable balances that they need to address.
On the other hand, an increasing or a high Quick Ratio can most commonly be due to a growth in sales and faster receivables collection. Such companies usually exhibit a more rapid Cash Conversion Cycle than the industry average.
We should always analyze the Quick Ratio together with other liquidity ratios, in the context of the industry where the business operates. Looking at the historical development of the rate can also help us to gain a better understanding of the company’s liquidity position.
The timing of capital expenditures, varying collection and payment terms and policies, doubtful debt allowances, and others can have a significant impact on the Quick Ratio calculation. The working capital needs also vary between industries, which can also affect the calculation of the measure. We should perform liquidity benchmarks on companies within the same industry to get more meaningful insights. Another metric we can compare against is the industry average.
We need to be aware that a Quick Ratio above the industry average is not always a good sign. It can mean the company has tied up too much cash in assets with low return (quick assets), instead of investing in long-term, higher yield assets.
Quick Ratio Disadvantages
There are some drawbacks to the Quick Ratio and its use in financial analysis.
- We solve the formula under the assumption that Accounts Receivable are readily available for collection, which may not be the case in reality.
- The measure assumes that the company can and is willing to liquidate all of its current assets to cover current obligations. This is not realistic, as the business requires some levels of Working Capital to operate.
- The Quick Ratio provides no info on the timing of the cash flows. If a large portion of Accounts Receivable is collectible in 90 days and significant crucial business expenses are due for settlement in 30 days, the ratio will show a good picture for the company. At the same time, the business will be about to run out of cash.
- The calculation is based on historical data and gives us no guidance for the future performance of the company.
- The measure does not consider possible upcoming expenses that can significantly drain cash on hand, like dividends, capital expenditures, legal claims and others. Some of these can be unexpected and lead to a considerably worse Quick Ratio for the subsequent periods.
Example Use of the Quick Ratio in Financial Modeling
The Quick Ratio is not a typical financial modeling tool. It is a very robust way to gauge the financial health of a company, but in this example, we wanted to show you how you can apply it within financial modeling.
Below is a table showing us historical data of Current Assets and Current Liabilities for the financial years 2016 to 2020.
We have calculated the Quick Ratio below by applying the formula mentioned above. However, the business under review is one that can liquidate finished goods almost instantly. Therefore, we have included this line item in our calculation as well.
Below we have the same excerpt from our FY 2021 Budget. We have calculated a forecast for the Balance Sheet and we plan to have a significant reduction in Finished Goods as of year-end due to planned maintenance in December. The result is that our factory will be closed for most of the month and won’t produce any goods.
However, when we calculate the Quick Ratio for our budget, we notice that it’s below 1, which is a signal that the business might face some cash flow struggles. We know the reason behind this (our scheduled maintenance) but a budget Balance Sheet like this can be misleading to potential investors, not well informed on our maintenance schedule.
Analysts might calculate some basic horizontal changes and notice the significant increase in raw materials and a decrease in finished goods.
We can make the following proposition to mitigate this risk and the potential adverse effect on the company. We postpone the maintenance work to January of next year. Doing so will allow us to produce € 78 mil worth of product, by using € 70 mil raw materials. We will then adjust the balances of raw materials and finished goods. It will also affect our other payables with € 8 mil. The amount represents the additional salaries that go into the processing of materials to products, which we will add to the payable salaries at the end of the period (paid in the following month).
By doing so, we will be able to show a healthy Quick Ratio for our FY 2021 budget to our potential investors and other stakeholders.
It is essential to be aware that this is a very simplified example, and may not always be applicable. However, I remember doing this once for some internal department budgets, and the higher management received it positively.
A good Quick Ratio is a signal to investors and other stakeholders of competence and stable business performance. It shows the potential for sustainable growth and portrays the company as a sound investment choice.
The Quick Ratio we discussed is very similar to the Current Ratio, but analysts consider it a more reliable indicator of the short-term financial strength of the firm. Lenders and other creditors prefer the Quick Ratio, as it shows the firm’s ability to pay its obligations in the worst possible conditions.
When employing the metric in our financial analysis and modeling endeavors, it is crucial to remember the inherent drawbacks and adjust our strategy to mitigate these with additional examination and tests.
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