Business Financials – Quick Ratio formula, Meaning & v Current Ratio
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Published on Friday, 11 October 2024 09:04
The Quick Ratio formula is a valuable metric for assessing a business's financial well-being. It’s meaning is it serves as an indicator of a company's short-term liquidity and evaluates its capacity to fulfill short-term obligations using its most liquid assets, typically within a three-month period. This ratio, often referred to as the acid test, highlights the firm's ability to quickly utilize near-cash assets—those that can be swiftly converted into cash—to settle current liabilities.
Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets.
The formula for the Quick Ratio (QR) is:
Quick Ratio (QR) = Current Assets less Inventory / Current Liabilities
Example –
Consider a retail store with the following financials:
- Cash: $2,000
- Accounts Receivable (Lay-by): $3,000
- Inventory: $12,000 (not included in quick assets)
- Current Liabilities: $3,500
To calculate the Quick Ratio:
QR - (2,000 + 3,000) / 3,500 = 1.43
This means the store's quick assets are 1.43 times greater than its current liabilities.
The Quick Ratio utilizes current assets that can be converted to cash within 90 days or in the short term. Quick assets include cash, cash equivalents, short-term investments, marketable securities, and current accounts receivable.
Short-term investments or marketable securities encompass trading securities and those available for sale, which can be readily converted into cash within the next 90 days.
The Quick Ratio provides insight into a company's ability to meet its current liabilities (payroll tax, super, short loans and credit cards). If a business has sufficient quick assets to cover its total current liabilities, it can fulfill its obligations without needing to liquidate any long-term or capital assets.
Since businesses typically rely on long-term assets for revenue generation, selling these capital assets could harm the company's financial standing and signal to investors that current operations are insufficiently profitable to cover liabilities.
A Quick Ratio of 1 indicates that quick assets are equal to current liabilities, suggesting the company can settle its obligations without liquidating long-term assets. A ratio of 2 implies that the company possesses twice as many quick assets as it has current liabilities.
Higher Quick Ratios are advantageous for companies as they indicate a greater amount of quick assets relative to current liabilities. The Current Ratio, which includes inventory, is similar to the Quick Ratio but provides a broader view of liquidity.
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