Why is Quick Ratio Important for a Business?

Financial Ratios are crucial for any company as they indicate the performance overview of a company without looking at its Financial Statements.

These ratios are significant for all the stakeholders of the company, whether they are investors, employees, customers, or suppliers.One of the most vital inclusions among all the financial ratios is the Quick Ratio. So, let us understand what it is and how important it is for any business.

What is Quick Ratio?

Quick Ratio, also known as the Acid-test ratio, measures the liquidity of a business. How nicely a company caters to its short-term obligations? How fast a company converts its short-term assets to pay off its short-term liabilities? Quick ratio answers these queries.

You can calculate it as:

Quick ratio = (Cash and cash equivalents + Accounts receivable + Marketable securities) / Current liabilities

OR

Quick ratio = (Current assets – Prepaid expenses – Inventory) / Current liabilities

In simple words, it denotes the ability of a company to meet its short-term liabilities with its quick assets/liquid assets.

Quick assets are assets like cash and other near-cash assets that can turn into cash within 90 days). Current liabilities are the dues that you need to be pay within 1-year of time.

Here, if you observe the second formula, inventory is removed from the current assets while calculating quick assets. Because a company can not sell all its inventory (Finished goods, Work-in-Progress, Raw Material) within 90 days. If it tries to sell within 90 days, they might have to offer promotions and discounts, which will decrease the revenue.Similarly, you have to include accounts receivables within 90 days.

Quick ratio highlights the firm’s capacity to pay its current liabilities by only using its most liquid assets. A higher ratio for any given company depicts better liquidity, while a lower ratio implies less liquidity.

The ideal ratio considered is 1, which means that the firm can pay all its current liabilities or liabilities arising in one-year by using its quick assets or the assets available within just 90 days.

No doubt, the quick ratio is a more conservative figure than the current ratio, as we check the ability of a company to pay its liabilities arising in one-year with just its assets of 90 days.

Let us get more clarity with an example:

We have taken 4 companies with their quick ratios. So, what do they show us about the company’s liquidity position?

• According to the definition, C Ltd. has the ideal quick ratio that means it has just enough quick assets to pay out its current liabilities. B Ltd. also has a ratio closer to 1 which is decent enough.
• D Ltd. has a ratio higher than 1, which means that it has more than enough liquid assets to clear its liabilities of one-year.
• On the other hand, A Ltd. may not be able to pay its current liabilities using quick assets as the ratio is just 0.6, which means the quick assets is only 60% of its current liabilities.

Is 1 the Ideal Quick Ratio in the Real World?

There are many views in the market which all are correct in different situations. Let’s have a look:

• Higher Opportunity Costs: Many experts believe that a higher quick ratio leads to higher opportunity costs if the firm is keeping a lot of cash with itself that is lying idle. This cash is not in use, and if put in business or invested somewhere else, would gain you some profit or interest.

• Industry matters the most: Some even believe that this parameter is not good or bad in itself unless compared with the industry ratio, and what ratio the market leaders in that industry and other competitors have. So, if most of the players including big businesses have a lower quick ratio, it may hint for a lower ratio to be good, and to run the business, you do not need more liquid assets. But, you know, the reverse is also true and generally acceptable.

Importance of Quick Ratio

By now, you might have understood the importance of financial ratios.The Quick Ratio is an indicator that displays the firm’s capacity to pay its current liabilities by using its most liquid assets. Usually, a higher quick ratio for any given company portrays better liquidity and vice-versa.

An easy and fast number to calculate, a quick ratio is a popular metric to assess a company’s financial health. However, it is more useful for comparisons in the same industries owing to certain limitations. You may need to analyze other financial elements impacting a business before coming to any conclusions.

If you want to add the Calculator to the above post:

Embed code for Quick Ratio Calculator: