Understanding Quick Ratio: Definition, Formula, and Examples

When it comes to assessing the financial health of your business, liquidity is key. One of the most reliable metrics used to measure this is the quick ratio—a powerful indicator of your company's ability to meet short-term obligations without relying on inventory. 

Unlike other liquidity ratios, the quick ratio gives a clearer picture of how easily your business can convert assets into cash to pay off debts.

In the Indian market, companies like Coal India and Global Education have demonstrated varying financial performances. Coal India showcases a quick ratio of 1.48. Meanwhile, Global Education has a quick ratio of 7.34. 

While these figures fluctuate, they offer a snapshot of each company's current liquidity and ability to handle liabilities.

This blog explores the definition, formula, and real-world examples of quick ratio, offering a clear understanding of its importance and how it can strengthen your business's financial stability. 

Dive in!

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What is Quick Ratio?

The quick ratio, also known as the acid-test ratio, is a financial metric used to measure a company's ability to meet its short-term obligations using its most liquid assets. It includes only such liquid assets that may be converted into cash within 90 days without adversely impacting its price. 

Unlike the current ratio, which considers all current assets, the quick ratio focuses only on assets that can quickly be converted into cash, excluding inventory. This makes it a more stringent test of a company's short-term liquidity. 

The quick ratio is calculated using the following formula:

• Cash and Equivalents: These are the most liquid assets readily available to pay off obligations.
• Marketable Securities: Short-term investments that can be sold quickly.
• Accounts Receivable: Money owed to the company by customers, expected to be collected soon.
• Current Liabilities: The company's short-term debts or obligations must be settled within a year.

A quick ratio of 1 or higher means that your company has enough liquid assets to cover current liabilities without selling inventory. A ratio below 1 suggests that you may struggle to meet its short-term obligations. 

It is crucial for creditors and investors as it offers insight into your company's liquidity and ability to remain solvent soon. It helps assess whether your business is financially healthy enough to handle unexpected expenses or economic downturns.

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What is a Good Quick Ratio?

The quick ratio is a valuable metric, but simply knowing the formula isn’t enough to gauge what qualifies as "good." The true value of a quick ratio depends on how well a company balances liquidity with growth.

 Here’s a deeper look into what various quick ratios reveal about your business's health.

Also Read: Also Read: Uses, Importance, and Types of Financial Analysis. 

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How to Calculate the Quick Ratio: Real Brand Example 

The quick ratio excludes inventory, prepaid expenses, and other less liquid assets, focusing only on cash, receivables, and other near-cash assets.

To illustrate how this works in the real world, look at relevant data from Tata Motors’ balance sheet from March 2024.  

Here’s the quick ratio breakdown for Tata Motors based on these numbers. 

Tata Motors has a quick ratio of 0.35, which means it has ₹0.35 in highly liquid assets for every ₹1 of current liabilities. This suggests that Tata Motors would rely on its inventory or other means to cover its short-term obligations since its quick assets are insufficient to meet its liabilities fully. 

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What is the Quick Assets Formula? 

When evaluating your liquidity, quick assets are often calculated by excluding less liquid current assets like inventory and prepaid expenses from the total current assets (TCA). This provides a more accurate picture of how quickly you can convert assets into cash to cover immediate liabilities.

The formula for calculating quick assets is:

Quick Assets = TCA − Inventory − PE

Where:

• TCA stands for total current assets, which includes all assets your company expects to convert into cash within a year.
• Inventory represents the stock of goods your company holds, which may not be easily sold quickly without impacting prices.
• PE stands for prepaid expenses, which are payments made in advance for services to be consumed in the future. They are not readily convertible into cash.

By excluding inventory and prepaid expenses, you focus on more liquid assets like cash, cash equivalents, and accounts receivable. This refined calculation of quick assets helps you assess your ability to pay off your current liabilities more conservatively.

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Quick Ratio Vs. Current Ratio 

The current ratio measures a company’s ability to meet its short-term liabilities using its short-term assets. It is a basic liquidity indicator that shows whether a company can cover its immediate obligations with its current assets. 

The current ratio includes all current assets, such as cash, marketable securities, accounts receivable, prepaid expenses, and inventory, along with current liabilities, such as short-term debt, accounts payable, and accrued liabilities.

Current Ratio Formula: 

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For example, if a company has ₹50,00,000 in current assets and ₹25,00,000 in current liabilities, the current ratio would be: 

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A current ratio of more than 1 indicates that the company has more current assets than liabilities. In contrast, a ratio of less than 1 suggests financial risk, as the company may struggle to meet its short-term obligations.

Here are the key differences between the current and quick ratios. 

Includes only cash and accounts receivable, which are the most liquid assets.

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When to Use the Quick Ratio vs. the Current Ratio?

Choosing between the quick ratio and the current ratio depends on the context of your financial analysis. Each metric provides unique insights into a company’s liquidity, but their effectiveness varies based on the situation.

1. Quick Ratio: Ideal for Short-Term Liquidity and Volatile Markets

The quick ratio is a great tool for you when analyzing shorter time frames or if your industry faces inventory obsolescence. Let’s say your company has ₹10 crore in current assets, but 85% of that is tied up in inventory. If you have only 30 days to liquidate assets and settle liabilities, relying on the current ratio could give you an overly optimistic view. 

The quick ratio, which excludes inventory, provides you with a much clearer picture of your company’s actual liquidity during these tight deadlines. This ratio is also more accurate if your business operates in a fast-moving industry, where inventory can become outdated quickly.

 For example, if your warehouse is stocked with goods that lose demand due to sudden market shifts, using the current ratio could overstate your liquidity, especially before you’ve adjusted inventory values. 

The quick ratio helps you avoid this by focusing only on assets that can be converted to cash quickly.

2. Current Ratio: Better for Long-Term Analysis and Simpler Calculations

The current ratio is better for you when your company isn’t dealing with immediate capital constraints. 

If your business can raise funds through investments or other sources, the current ratio offers a clearer picture of liquidity over a longer timeframe, typically the next 12 months. It shows your ability to cover liabilities without selling off assets at a loss.

The current ratio is often a more practical choice for evaluating liquidity, especially when dealing with balance sheets that don't provide detailed asset breakdowns. This is because the current ratio only requires information about current assets and current liabilities, which are typically readily available in financial reports. In contrast, the quick ratio requires a more granular breakdown of current assets, excluding inventory and prepaid expenses, which might not be easily accessible in all financial statements.

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Importance and Benefits of the Quick Ratio

In March 2024, Nestle India reported a 5-year low quick ratio of 0.3x, raising concerns about its short-term liquidity. This low ratio highlights the importance of understanding how the quick ratio can impact a business's ability to manage its immediate financial obligations. 

A company's liquidity plays a crucial role in maintaining smooth operations, especially during economic challenges or unexpected expenses. 

Here’s why the quick ratio is essential for businesses and how it benefits overall financial health. 

1. Accurate Short-Term Liquidity Check

The quick ratio precisely measures your company's ability to meet short-term liabilities without relying on less liquid assets like inventory. This gives you a realistic view of your immediate financial health.

2. Reduces Overestimation of Liquidity

Excluding inventory and prepaid expenses offers a more conservative measure of liquidity. This ensures you don’t overestimate your ability to cover debts, helping you avoid financial missteps.

3. Better Preparedness for Financial Obligations

With the quick ratio, you can assess whether you have sufficient cash or near-cash assets to settle liabilities swiftly, keeping you prepared for unexpected financial demands.

4. Essential for Risky or Fast-Moving Industries

In industries where inventory can become obsolete or lose value quickly, the quick ratio is particularly important. It prevents overreliance on inventory when assessing liquidity, making it a crucial metric for fast-paced sectors.

5. Builds Investor and Creditor Confidence

A strong quick ratio indicates financial stability, making your business more attractive to investors and creditors. It shows your ability to meet obligations without needing to sell off inventory, boosting trust. 

Also Read: Does Your Company Have the Right Capital Mix?

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Conclusion 

In this blog, you’ve explored the quick ratio, a critical tool for entrepreneurs like you to assess your company’s short-term liquidity. By focusing only on liquid assets, the quick ratio offers a more accurate picture of how well your business can handle immediate financial obligations without relying on inventory or prepaid expenses. 

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FAQs

Q1. What is the quick ratio?
A. The quick ratio, also known as the acid-test ratio, is a financial metric that measures a company’s ability to pay off its short-term liabilities using its most liquid assets. It excludes inventory, providing a more stringent view of a company’s liquidity than the current ratio.

Q2. How do you calculate the quick ratio?
A. The quick ratio is calculated using the formula: Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities. This formula focuses on liquid assets that can be quickly converted to cash, ensuring companies can meet short-term obligations without relying on less liquid assets.

Q3. Why is the quick ratio important?
A. The quick ratio is important because it offers insight into a company’s short-term financial health. It helps businesses and investors assess if a company has enough liquid assets to cover its immediate liabilities, which is crucial during economic downturns or sudden financial demands.

Q4. What is a good quick ratio?
A. A good quick ratio is typically 1 or higher, indicating that a company has enough liquid assets to cover its current liabilities without relying on inventory. Ratios above 1 show stronger liquidity, while ratios below 1 may signal potential liquidity problems.

Q5. What is the difference between the quick ratio and the current ratio?
A. The quick ratio excludes inventory and prepaid expenses, focusing only on the most liquid assets, while the current ratio includes all current assets. The quick ratio offers a more conservative measure of liquidity, making it more useful for short-term financial analysis.

Q6. Why is inventory excluded from the quick ratio?
A. Inventory is excluded from the quick ratio because it may not be easily converted to cash without incurring a loss. The quick ratio focuses on assets that can be turned into cash quickly, providing a more accurate measure of a company’s ability to meet short-term obligations.

Q7. How can a company improve its quick ratio?
A. A company can improve its quick ratio by increasing liquid assets like cash and receivables or by reducing current liabilities. Managing debts efficiently, improving cash collections, and reducing reliance on inventory can also strengthen the quick ratio.

Q8. What does a low quick ratio indicate?
A. A low quick ratio, typically below 1, indicates that a company may struggle to meet its short-term liabilities with its liquid assets. This could be a red flag for investors and creditors, suggesting the business may face liquidity challenges in the near future.

Q9. Can a quick ratio be too high?
A. Yes, a very high quick ratio could indicate that a company is not effectively using its liquid assets to grow the business. While a high ratio shows strong liquidity, it may also suggest that the company is holding excess cash or marketable securities instead of investing in growth opportunities.

Q10. When should I use the quick ratio over the current ratio?
A. The quick ratio is more suitable when you need a conservative view of a company’s liquidity, especially in industries where inventory is less liquid or may become obsolete quickly. It’s ideal for short-term financial analysis, while the current ratio is better for long-term liquidity assessments.