Quick ratio Definition
Quick ratio or acid test ratio is the ratio of quick assets to all current liabilities. Quick assets for this purpose include cash, marketable securities and good debtors only. In other words, prepaid expenses and inventories are not included in quick assets because there may be a doubt in quick liquidity of inventory.
Quick ratio (Acid-test ratio) ratio is a more rigorous test of a firm’s ability to pay its obligations. The quick ratio takes into account the fact that some accounts classified as current assets are less liquid than others. Current Assets often include slow-moving inventory items and other items which are not very liquid.
For example, inventories may take several months to sell; also prepaid expenses only serve to offset otherwise necessary expenditures as time elapses. These are subtracted from current Assets to arrive at quick assets which are divided by current liabilities to get the acid-test ratio. Thus, the quick ratio attempts to measure the immediate debt-paying ability of the firm.
Quick ratio or Acid-test ratio is a more conservative measure as it relates to the “pool” of cash and immediate cash inflows to immediate cash outflows. The old rule of thumb here was that a quick ratio of
at least 1:1 would keep the creditors happy. A low ratio could indicate possible difficulties in the payment of bills.
Financial ratios are based on a given income statement and balance sheet. And in a dynamic world, we have to supplement the financial statement given at a point of time with a trend analysis of changes that have occurred over time.
Quick Ratio Formula:
The formula of quick ratio or acid test ratio is given below:
Quick ratio or acid test ratio = Quick assets / Current liabilities
The following data has been obtained from the balance sheet of Fine Trading Company:
- Cash: $90,000
- Marketable securities: $65,000
- Accounts receivable: $200,000
- Prepaid expenses: $15,000
- Inventory: $350,000
- Accounts payable: $95,000
- Notes payable: $10,000
- Accrued expenses: $25,000
- Short-term loan: $200,000
Using the above data, calculate quick ratio of Fine Trading Company.
Quick ratio = Quick assets / Current liabilities
= 1.08 or 1.08 : 1
*$90,000 + $65,000 + $200,000
**$95,000 + $10,000 + $25,000 + $200,000
The quick ratio of Fine Trading company is 1.08 which looks comfortable for a trading company. Quick ratio provides a more strict test of liquidity than current ratio. A quick ratio of 1 : 1 or higher is considered satisfactory for most of the companies.