What is a Quick Ratio?
The quick ratio measures a company’s ability to use liquid assets (those it can quickly turn into cash) to pay debts owed within a year.
🤔 Understanding quick ratios
Also called the acid test ratio, the quick ratio is one tool to help you understand the financial health of a company. It’s a measure of liquidity, or the ability of a company to use its most liquid assets (cash and other assets that can quickly turn into cash without affecting their price too much) to cover current liabilities (money due to creditors within a year). You calculate the quick ratio by dividing the value of a company’s most liquid assets (like cash, marketable securities, and money customers owe for goods and services) by its current liabilities. A ratio of 1 or higher means a company has enough — or more than enough — liquid assets to pay off short-term obligations quickly. A ratio lower than 1 suggests the company doesn’t have enough on hand to speedily pay off short-term debts.
Let’s take a look at Amazon’s quick ratio for the quarter ending Sept. 2019. The company’s balance sheet lists the following figures:
Current assets (excluding inventory): $60.3B Current liabilities: $72.1B Quick ratio: 0.84 (60.3/72.1) (Source: Amazon Form 10-Q, Sept. 2019)
Amazon’s quick ratio is below 1, meaning its current assets can’t cover its short-term obligations. This doesn’t mean it’s likely that Amazon will have trouble paying suppliers. Amazon continues to have revenue growth in the double digits and can increase profitability by slowing investments if it needs to conserve cash. It’s important to understand that the quick ratio doesn’t give a complete picture of a company’s health, and the average ratio differs by industry. But this is one way to compare Amazon to other companies or the industry average.
The quick ratio is like checking your pulse...
Just as your pulse doesn’t tell the whole story about your current health, the quick ratio doesn’t give you a complete account of the overall health of a company. But it’s a fast and handy indication of how financially healthy a company is on a short-term basis.
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What does the quick ratio tell you?
The quick ratio gives you a sense of the short-term financial health of a company. It measures a company’s ability to pay its current liabilities (amounts due to creditors within a year, like payments to suppliers, short-term debt, and dividends) using its liquid assets (those that can be converted to cash within one year, like accounts receivable, marketable securities, and cash or cash equivalents). These liquid assets are listed among a company’s current assets.
Accounts receivable are payments a company’s customers owe for goods or services they’ve already ordered. Marketable securities are things like common stock or government bonds that a company can sell within one year.
The quick ratio is sometimes called the “acid test ratio,” since you can calculate it quickly based on details in a company’s balance sheet.
If the quick ratio is below 1, that means the company cannot meet its short-term obligations using only its most liquid current assets. In general, this could indicate the company may struggle to pay suppliers or other expenses and debts if it runs into problems in the coming year. If the ratio is 1 or higher, that means that the company can use current assets to cover liabilities due in the next year.
For example, if a company has a quick ratio of 0.8, it has $0.80 of current assets for every $1 of current liabilities. On the other hand, if a company has a quick ratio of 1.5, it has $1.50 of current assets for every $1 of current liabilities.
How do customer payments affect the quick ratio?
Customer payments, otherwise known as accounts receivable, are one of the main components of current assets, along with cash or cash equivalents and marketable securities. They can also make the quick ratio a little misleading.
A company may have a high accounts receivable balance, meaning clients owe it lots of money. This raises the quick ratio, suggesting the business can cover all current liabilities with its most liquid current assets. However, the payment terms for customers may be 120 days or longer. That would make it difficult for the company to use those funds for short-term liabilities, especially if supplier payments are due sooner.
On the other hand, a company may have shorter payment terms on accounts receivable but longer payment terms for suppliers. This could give the business a lower quick ratio. However, it may still be able to pay those short-term liabilities easily because it receives money from customers much faster than it pays vendors.
What is a good quick ratio?
In general, a decent quick ratio is at or above 1. That means that a company can fully cover liabilities it owes in the next year using easily accessible assets. If the ratio is less than 1, it may be more difficult for the company to meet those obligations.
Remember that the quick ratio is a general health check for a company and doesn’t give a complete financial picture. Average quick ratios vary by industry. For example, retailers generally have lower quick ratios than most other sectors because they have a lot of inventory (which isn’t part of the quick ratio calculation).
It may be best to use the quick ratio to compare two companies in the same sector or compare one company to the industry average. It’s also good to use the quick ratio along with other indicators (for example, the debt-to-equity ratio) when assessing the overall health of a company.
What is the quick ratio vs. the current ratio?
The quick ratio measures a company’s ability to cover short-term obligations (current liabilities) using only its most liquid assets (accounts receivable, marketable securities, cash, and cash equivalents). The quick ratio excludes inventory (the goods a company plans to sell), supplies (like paper) and prepaid expenses (those paid for in one accounting period but used later, such as insurance or prepaid rent). The quick ratio focuses only on current assets that are easy to liquidate, or sell quickly without affecting their price much. Inventory is generally difficult to sell quickly at or near market price, and prepaid expenses cannot be used to pay for current liabilities.
The current ratio also measures liquidity, or how easily a company can cover short-term obligations (those due within one year) with assets that can quickly be turned into cash. It uses items from the same section on the balance sheet as the quick ratio (current assets and current liabilities), but it also includes inventory and prepaid expenses under current assets. Since it considers more assets to be liquid, the current ratio is a bit less conservative than the quick ratio when judging short-term financial liquidity.
What is the quick ratio formula?
There are two formulas for the quick ratio:
Both formulas use information from the same section of the balance sheet. In the first formula, you add up the current assets that are considered most liquid: cash or cash equivalents, marketable securities, and accounts receivable. In the second formula, you take total current assets and subtract inventory and prepaid expenses. Both formulas should give you the same result.
How do you calculate the quick ratio?
For publicly traded companies, you can usually find the information you need to calculate the quick ratio in the balance sheets included in their quarterly or annual reports.
Let’s compare two competitors in the retail sector, Walmart and Amazon. Even though both companies are in the same industry, they have different quick ratios, which reflects their divergent business models.
First, find their most recent quarterly reports and go to the balance sheet. Add up their current assets, excluding inventory or prepaid expenses. Then, divide the sum by total current liabilities. This gives you the quick ratio.
|Quick Assets (current assets, excluding inventory and prepaid expenses)||$14.2B||$60.3B|
(Amazon Form 10-Q, Sept. 2019; Walmart Form 10-Q, Oct. 2019)
Walmart has a lower quick ratio, meaning it only has $0.17 of liquid assets for every $1.00 of current liabilities. It would be much more difficult for Walmart to cover its short-term obligations than for Amazon to do so.
However, the difference in the quick ratios also reflects the retailers’ different business models. Remember that you exclude inventory from the quick ratio. Walmart has more physical stores, so it carries more inventory, whereas Amazon operates mostly online, requiring it to have less stock. According to Amazon’s 2018 annual report, nearly 58% of the value of goods sold on the platform came from third-party sellers, meaning Amazon didn’t hold that inventory. Since more of Walmart’s current assets consist of inventory, which doesn’t make it into the equation, its quick ratio is lower than Amazon’s.
In the end, the quick ratio is a good place to start if you want a conservative measure of the short-term health of a company.
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