Quick Ratio

Lesson

The quick ratio, also known as the acid-test ratio, is a financial metric used to measure a company's short-term liquidity by comparing its most liquid assets to its current liabilities. It is a more conservative measure of liquidity than the current ratio, as it excludes inventory from the calculation. A higher quick ratio indicates that a company can better meet its short-term obligations without relying on the sale of inventory.

Practice Question #1

Which of the following is NOT included in the calculation of the quick ratio?

Terms

Quick Ratio:

A financial metric used to measure a company's short-term liquidity by comparing its most liquid assets to its current liabilities.

Acid-Test Ratio:

Another name for the quick ratio.

Current Assets:

Assets expected to be converted into cash, sold, or consumed within one year or one operating cycle.

Current Liabilities:

Obligations expected to be settled within one year or one operating cycle.

Liquidity:

The ability of a company to meet its short-term financial obligations.

Inventory:

Goods and materials a company holds for resale or production.

Current Ratio:

A financial metric that measures a company's ability to pay its short-term obligations, calculated as current assets divided by current liabilities.

Practice Question #2

A company has a quick ratio of 1.5. What does this indicate about its short-term liquidity?

Do Not Confuse With

Current Ratio:

A less conservative measure of liquidity that includes inventory in the calculation.

Practice Question #3

Which of the following financial ratios is a more conservative measure of a company's short-term liquidity?

Historical Example

In the early 2000s, a major telecommunications company faced financial difficulties due to its high debt levels and declining revenues. Financial analysts noted that the company's quick ratio had dropped significantly, indicating it struggled to meet its short-term obligations. This ultimately led to the company filing for bankruptcy protection.

Real-World Example

A small retail business has $50,000 in cash, $30,000 in accounts receivable, $20,000 in inventory, and $40,000 in current liabilities. The quick ratio is calculated as ($50,000 + $30,000) / $40,000 = 2.0, indicating that the business has sufficient liquidity to meet its short-term obligations without relying on the sale of inventory.

Formulas to Remember

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Formula Examples

Company ABC has the following financial information: - Current Assets: $10,000 - Inventory: $4,000 - Current Liabilities: $5,000 Quick Ratio = ($10,000 - $4,000) / $5,000 Quick Ratio = $6,000 / $5,000 Quick Ratio = 1.2

Pitfalls to Remember

Non-liquid assets:

The quick ratio may not accurately represent a company's liquidity if significant non-liquid assets are included in current assets.

Seasonal fluctuations:

The quick ratio may not be a reliable indicator of liquidity for companies with seasonal fluctuations in inventory and sales.