What is Quick ratio?
As part of liquidity ratios, apart from the Current Ratio, another important ratio is the Quick ratio or Acid test ratio.
Similar to the current ratio, even the Quick ratio is very easy to calculate and interpret.
Since it highlights the liquidity position of any company clearly, it is one of the most widely used liquidity ratio by investors and lenders.
Quick ratio meaning
The Quick ratio, also called as Acid test ratio helps in understanding if the company has sufficient assets that can be converted to cash quickly and use the proceeds to pay off its current liabilities.
Such assets that can be converted into Cash in a very short period is called Quick Assets.
Companies with relatively high quick assets will always manage to convert such assets into cash and pay off the current liabilities without any difficulty.
Hence, the Quick ratio for such companies would be generally high. This indicates the better liquidity position of the company.
Now, let us look understand the formula in depth.
Quick ratio formula
The formula for the quick ratio is related to the Current ratio formula.
We take Quick Assets in the numerator and Current Liabilities in the denominator.
Both the values can be obtained from the Balance Sheet.
As already highlighted above, Quick assets basically refer to those current assets that can be quickly converted into cash.
Current Liabilities refer to the obligations that the company is expected to fulfill within the current operating period. This generally includes payment due to suppliers and other accrued expenses.
Below are few important considerations with regards to the formula
Quick Assets include only below-given current assets
- Cash and cash equivalent
- Marketable securities
Other current assets which do not form part of Quick Assets are
- Prepaid expenses.
- Other current assets
Hence, it is important to note that items like Inventories and Prepaid expenses which are often recorded as part of current assets are not to be considered.
The reason why Inventories and Prepaid expenses are not considered in Quick ratio formula is that these assets cannot be converted into cash in a short span of time unlike Receivables and Marketable securities.
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Quick ratio formula example
Let us understand the Acid test ratio formula using a simple example.
Consider the below-given companies- Company A and Company B.
The values given below are in USD millions.
We are given the Balance Sheet extract for both the companies through which we can calculate the quick ratio easily.
To calculate the Quick ratio we need Quick assets and Current liabilities.
Let us calculate the Quick Assets for both the companies.
In the above example, let us add the below items which form part of Quick assets
- Cash and cash equivalent
- Marketable securities
Inventories Prepaid expenses
Similarly, let us add all the Current liabilities. In the given example we have only three items
- Accounts payable
- Short term loan
- Other short term liabilities
When we add all the Quick assets and Current liabilities for the respective companies we get below values.
- Quick assets = $110 + $30 + $80 = $220
- Current liabilities =$110 + $30 + $80 =$220
- Quick assets = $120 + $20 + $120 = $260
- Current liabilities =$400 + $100 + $300 =$800
Calculating the Quick ratio.
Quick ratio = Quick assets / Current Liabilities
Company A =$ 220/ $220 = 1 times
Company B = $260/ $800 = 0.32 times
Hence, the Quick ratio for Company A is 1 times while Company B is only 0.32 times.
Ideally, it is preferred to have a Quick ratio which is greater than 1. This makes sure that the company has sufficient assets to pay off its quick liabilities.
When we look at Company A, both Quick Assets and Current liabilities are exactly the same. Hence, it can pay off its Current liabilities comfortably.
On the contrary, Company B has inadequate Quick assets. Hence, the ratio is less than 1.
When compared to both companies, Company A has a relatively strong liquidity position as against Company B whose Quick ratio is less than 1.
How to calculate Quick Ratio using excel
To understand the practical application of the ratio, let us calculate the Acid test ratio for Walmart in excel.
You can download the Quick ratio template using the below option.
After you download the template you will see the consolidated Balance Sheet of Walmart and related calculation using excel.
Below given is the Balance Sheet extract showing the total assets of Walmart.
When we add all the Current assets like Cash and cash equivalent, Receivables (excluding Inventories, Prepaid expenses & Other current assets), we get total Quick Assets of $14,005.
Now, consider the below-given Balance Sheet extract showing Equity and liabilities.
Similar to above, when we add items like Accounts payable, Accrued expenses, Short term debt, Lease obligations & other quick liabilities, we get Current liabilities of $77,477.
Now that we have all the values required we can calculate the Quick ratio.
Quick ratio= Quick Assets / Current Liabilities
= $ 14,005 /$ 77,477 = 0.18 times
As calculated above, the Quick ratio for Walmart is 0.18 times.
This means that for each dollar of Current liabilities, Walmart has only $0.18 worth of Quick assets which is really low.
As already discussed, Ideally, the ratio should be more than 1. But, in the case of Walmart, it is only 0.18 which is not a good sign.
Nonetheless, the conclusion should be drawn about the ratio only after relative comparison with peers and also after performing historical trend analysis
Quick Ratio or Acid test ratio interpretation
As already highlighted, the Quick ratio indicates if the company has sufficient Quick Assets that can be converted to cash in a short period to pay off current liabilities
Quick ratio less than 1
- If the quick ratio is less than 1, this indicates that the company does not have sufficient quick assets against its current liabilities.
- A low acid test ratio is perceived as a threat to the liquidity position of the company since the company may have insufficient Cash or Receivable balance.
- Although companies may have high Inventories or Prepaid balance, but these assets take a relatively long time to convert into cash.
Quick ratio greater than 1
- On the contrary, if the ratio is more than 1, this indicates that the Quick assets of the company are sufficient to meet its current liabilities.
- A high Acid test ratio is often considered as a better liquidity position of the company since the current liabilities can be paid without the need to tap other current assets like Inventories or Prepaid expenses.
- At the same time, if the company has a very high Quick ratio, it should not be analyzed in isolation.
- Unusually higher Receivable balance may lead to higher Quick Assets and thereby a high Quick ratio.
- Hence, such unusual Receivable balance also needs to be analyzed using the receivable turnover ratio or days sales outstanding.
Similar to Trend analysis for Current ratio, it is important to analyze the Quick ratio historically to identify any unusual pattern.
Performing Trend Analysis gives an idea about the sustainability of the performance in the near future.
Let us look at how the Facebook Quick ratio has changed historically
As evident in the chart above, Facebook was able to increase its Acid test ratio continuously for the past 4 years.
Back in 2014, the ratio was 9.04 times which increased to 12.64 times in a matter of only 3 years.
This indicates the efficient management of the company’s Cash and Receivable balance relative to its current liabilities.
But, for the year ended 31 December 2018, Company’s current liabilities increased significantly relative to Quick Assets, hence there was a dip in the Quick ratio.
Hence, performings a Trend Analysis helps in knowing if there are any unusual items that are expected to recur.
Comparison with similar companies
Apart from performing Trend Analysis, it is equally important to understand how different is the ratio when compared to other sectors.
This helps in understanding the industry dynamics.
Walmart vs Home Depot
Let us look at the ratio profile for companies in the retail sector like Walmart and Home Depot.
Generally, due to the tight working capital requirement, companies in the retail sector have a very low Quick ratio.
In the case of Walmart, as we can see in the chart above the quick ratio is moderately in the range of 0.1 to 0.3 times.
Although this ratio appears to be really low on a standalone basis, but it is important to compare the ratio to other similar companies.
There has been a consistent fall in the ratio for the past few years. This is in line with our Current ratio analysis for Walmart.
For the year ended 31 January 2019, the Quick ratio for Walmart is 0.18 times compared to 0.15 times during the previous period.
When we look at the ratio profit for home improvement retailer- Home Depot, we can see a slight improvement.
The company was able to increase its Quick ratio for the past few years on a continuous basis.
For the year ended 3 February 2019, the Quick ratio for Home Depot is 0.22 times which is lower than 0.34 times that the company reported in the previous period.
When we compare companies like Walmart and Home Depot with Amazon, clearly Amazon has an upper hand.
The Quick ratio in the range of 0.7 times to 0.9 times.
Efficient management of receivables and cash relative to its current liabilities helped Amazon to maintain a higher Quick ratio compared to other companies.
For the year ended for the year ending 31st December 2018, Amazon quick ratio is 0.85 times compared to 0.76 times in the previous period
Apart from the retail sector, when we analyze the companies in the Oil & Gas sector, the ratio profile is no different.
As evident from the chart above, when we look at the quick ratio for ExxonMobil, a US-based multinational & gas company, we can see the ratio is in the range of 0.4 to 0.5 times.
For the year ending 31st December 2018, ExxonMobil Quick ratio is 0.49 times which is almost similar to what the company reported in the previous period.
Facebook vs Google vs Microsoft
We have calculated the Quick ratio for various tech-based companies like Facebook, Microsoft and Google.
Let us analyze how different are the ratios when compared with companies like Walmart and Home Depot.
In the case of Apple, there has been a moderate increase in the ratio for the past 5 years.
The company generates a significant amount of cash and cash equivalents every year that helps the company in maintaining a healthy liquidity position.
For the year ending 28 September 2019, Apple Quick ratio is 1.38 times compared to 0.99 times for the corresponding previous period.
When compared to other tech companies, Facebook has the highest quick ratio.
This indicates the efficient management of quick assets compared to its current liabilities by the company.
As part of the liquidity ratio analysis for Facebook, we saw that generally, the company has relatively low current liabilities because of its business model. This helps the company in maintaining a healthy liquidity position.
As a result of all such factors, the company was able to increase its quick ratio significantly from 9 times to 12.6 times.
Now, for the year ending 31st December 2018, Facebook Quick ratio is 6.94 times.
The Quick ratio for Google over the past few years has been in the range of 4 times to 6 times which is relatively lower when compared with company like Facebook.
Currently, for the year ending 31st December 2018, Google Quick ratio is 3.76 times compared to 5 times for the corresponding previous period..
Lastly, when we analyze the ratio for Microsoft, we can see that it is in the range of 2.5 x to 3 times.
Although the company’s Revenue is increasing gradually, the company is unable to improve its Quick ratio.
This indicates a tight liquidity requirement under which the company is operating.
Nonetheless, the company is able to maintain a steady-state quick ratio for the past 5 years.
Currently, for the year ending 30th June 2019, Microsoft Quick ratio is 2.3 times which is marginally lower than 2.74 for the corresponding previous period.
How to improve the quick ratio?
As already discussed, the formula for Quick ratio is
Quick Ratio = Quick Assets / Current Liabilities.
We can now understand the various ways through which we can improve the Quick ratio.
Better receivable management
- Generally, Receivables are the major component of Current Assets. Hence, it is important to maintain a favorable receivable balance
- Increasing receivable balance indicates that it is becoming more and more difficult to collect money from customers.
Generate more cash and cash equivalent
- As already highlighted Cash is an important component of Quick Assets. Hence, companies need to increase their overall cash balance to increase the Quick ratio.
- Calculating liquidity ratios like Debtor Days helps in collecting customer dues timely and thereby increase overall cash balance.
Negotiate payment to suppliers
- Payment towards suppliers has to be made considering the working capital requirement. If feasible, the payment period should be extended such that it helps in a better liquidity position.
Repayment of borrowings or loans
- If the company has taken a loan as part of its operations, the balance due appear on the Balance Sheet as a liability.
- Hence, better payment terms should be negotiated from the borrower such that it does not drain the liquidity of the company.
- When feasible, the company must pay off its borrowings so that the overall liability decreases.
Scroll through below recommended resources or learn other important Liquidity ratios.