1. Definition
Quick ratio is also known as “acid test ratio” which is used to test the ability of a business to pay its short-term debts. It measures the relationship between liquid assets and current liabilities. Liquid assets are equal to total assets minus inventories and prepaid expenses.
Quick ratio = Liquid assets / Current liabilities
Low current ratio indicates possible difficulties in the prompt payment of future bills.
High current ratio indicates excessive cash or receivables both signs of lax management. It could also indicates that the firm is too cautiously ensuring sufficient liquidity.
2. General Rule
When quick ratio is equal to 1:1, it is considered an acceptable for most firms.
3. Example A
The following are the current assets and current liabilities of PQR limited.
Current assets: cash 2400; accounts receivable 12000; inventory 16000; prepaid expenses 600
Current liabilities: account payable 11600; accrued parables 1800; notes payable 600
Quick ratio = (current assets - inventory - other not quick current assets) / (current liabilities)
=(2400+12000) / (11600+1800+600)
=1.0286
This means that the quick ratio is 1.0286, indicating that the company’s quick current assets are 1.0286 times more than its current liabilities.
Quick ratio is considered a more reliable test of short-term solvency than current ratio because it shows the ability of the business to pay short term debts immediately. Inventories and prepaid expenses are excluded from current assets for the purpose of computing quick ratio because inventories may take long period of time to be converted into cash and prepaid expenses cannot be used to pay current liabilities. Generally, a quick ratio of 1:1 is considered satisfactory. Like current ratio, this ratio should also be interpreted carefully. Having a quick ratio of 1:1 or higher does not mean that the company has a strong liquidity position because a company may have high quick ratio but slow paying debtors. On the other hand, a company with low quick ratio may have fast moving inventories. The analyst therefore must have a hard look on the nature of individual assets.