Quick ratios act as accounting tools that evaluate the liquidity of a business. The ratios show the ability of companies and businesses to take care of their current liabilities with liquid assets. The quick ratio evaluates a company’s ability to generate money to pay bills that are due within the next 90 days, known as short-term liquidity. It is also termed the acid test ratio because it tells a company’s capacity to turn its liquid assets into quick income.
This article incorporates different aspects of quick ratios to give a comprehensive idea of the same.
Breaking Down Quick Ratios
Divide a company’s liquid or liquid assets by the payable liabilities, and it will show you its quick ratio. The ideal quick ratio is 1:1. A lower ratio will indicate low liquidity.
These are the company’s most easily convertible assets. They are quick and easy to convert into currency. The business shouldn’t pay any costs when converting liquid assets into cash. Cash equivalents include things like money market accounts, savings accounts, certificates of deposits, and treasury bills that mature in 90 days. These do not include other current assets that cannot be quickly converted to cash, like inventory and prepaid.
Current liabilities are short-term debts owed by a business that are due within the upcoming year. They are readily identifiable in the financial sheet of the work. Common account payables like wages, salaries, taxes, utilities, interest, and insurance are among the things. This also includes the present portion of long-term debt that must be repaid within a year.
Marketable assets typically don’t have these kinds of time-based dependencies. To keep accuracy in the calculation, one should only consider the amount that will be received in 90 days or less under normal circumstances. Assets like interest-bearing securities that are prematurely sold or withdrawn may incur fines or lose value relative to their book value.
Net Accounts Receivable
It is debatable whether accounts receivable are a reliable source of quick cash because it relies on the credit terms that the business offers to its clients. On the other hand, a business could bargain for quick payment from clients and get extended payment terms from vendors, which would prolong the life of liabilities. It might have a healthier quick ratio and be completely prepared to pay off its current obligations by converting accounts receivable into cash more quickly.
Merits of Quick Ratios
A company’s ability to use cash and other short-term assets as leverage may be essential in challenging situations. Therefore, some key advantages of quick ratios are:
- They determine whether a business has sufficient liquid assets to pay its debts in the short run.
- They aid in evaluating a company’s capacity to deal with unforeseen costs.
- They may indicate impending financial problems.
- They enable investors and lenders to make well-informed choices about investing in or lending money to the business.
Demerits of Quick Ratios
These quick ratios have a lot of drawbacks. The financial metric offers no insight into a company’s potential future cash flow action.
Assumption of Current Assets
The problem with the quick ratios is that it assumes a business can pay its debts with current assets. Companies typically use operating cash flow rather than current assets to try and meet their commitments. It only assesses a company’s capacity to endure a cash restriction. The calculation disregards the amount of a business to pay obligations out of operating cash flows.
Ignores Companies Liquidity
Quick ratio omission of other elements of a company’s liquidity, such as payment terms, negotiating power, and current credit conditions, is a drawback. The quick ratio, therefore, does not provide a complete view of liquidity. Analysts prefer combining the quick ratio with the current ratio and cash ratio to guarantee an end-to-end exposure to a company’s liquidity status. Analysts also contrast these ratios with business norms.
Readable Availability for Conversion
The quick ratio assumes that accounts payable are easily convertible. It does not take into consideration the unpaid accounts receivable, though. Additionally, receipt on the creditors’ financial standing. A debtor might not be able to make the required payments on time. The accounts outstanding will be changed to bad and doubtful debts in this circumstance. In conclusion, the money will be given even though it is not sure that the debtors will pay their obligations in full.
Significance of Quick Ratios
Different sectors may have different average quick ratios.
Low Quick Ratios
- A lower quick ratio is acceptable in sectors where cash flows are steady and predictable, such as the retail industry, because expected revenues can be relied upon to provide needed cash.
- A lower quick ratio can be acceptable to businesses that don’t mind taking on risk, whereas management that is risk-averse may favour a much higher ratio.
- It’s critical to boost quick ratios in times of economic turmoil so that the company can withstand unexpected disruptions.
High Quick Ratio
- A very high fast ratio indicates that not all of the business’s funds are being used. This could be an indication of inefficiency and cost the business money. It is preferable to lower the quick ratio to the industry norm if there is no particular need for a high quick ratio.
- A business expanding quickly might prefer a higher quick ratio to pay for capital expenditures and growth. Due to its established relationships with lenders and suppliers, a stable company may opt for a lower ratio.
The quick ratios offer an accurate depiction of a company’s cash liquidity. However, a researcher must think of all three account ratios – quick ratio, current ratio, and cash ratio, when assessing a company’s liquidity.
1. What is meant by quick Ratio?
The quick ratios show a company’s ability to cover its short-term obligations without trading inventory for more funding. Compared to the current ratio, which counts all current assets as coverage for current obligations, the quick ratio is a more conservative metric.
2. How do you calculate the quick ratio?
A company’s current cash and equivalents (such as marketable securities) and accounts payable are divided by its current obligations to arrive at the quick ratio.
3. Is a high or low quick ratio good?
In terms of the quick ratio, generally speaking, higher is better. A ratio higher than or equal to one is what you should strive for as a company. If the ratio is one or higher, your company has enough liquid assets to bear its short-term commitments.
4. What is the best quick ratio?
An excellent quick ratio is typically anything more than one or 1:1. If the ratio is 1:1, the company’s liquid assets and current liabilities are equal in quantity. A higher number means the business could more than cover its present liabilities.