Whereas the current ratio formula is:
Current ratio = current assets/current liabilities
The quick ratio formula is:
Quick ratio = current assets – (inventory + prepaid expenses)/current liabilities
In this way, the quick ratio is intensely focused on a company’s financial position, particularly its ability to quickly convert assets to cash. The higher the ratio, the more financially stable the company is said to be in regard to their short-term liabilities. Investors are looking for a company to have a quick ratio of above 1.0.
A low quick ratio or one that is declining can mean that the company is carrying too much debt (i.e. it is overleveraged). It can also mean it is not meeting its sales numbers, it is paying its bills too quickly, and/or collecting their accounts receivable too slowly. A high quick ratio or one that is improving is generally seen as an indicator of increasing revenue and profit (i.e. top-line growth). This can also mean that the company may have an inventory turnover ratio that lets them quickly convert inventory into cash.
The quick ratio has its limitations. One such limitation is that it does not give direction as to cash flow. Companies pay out their liabilities at different times which is a more accurate predictor of how easily a company can pay its bills. Also, by including accounts receivable, the quick ratio assumes that a company’s account receivables are immediately available for collection. However, that is not the case for many companies. But perhaps one of the largest limitations of the quick ratio is that it presumes that a company would, if necessary, liquidate all of their current assets to cover their current liabilities. Since business needs a certain amount of working capital to exist as a viable entity, the quick ratio cannot be used as anything more than a hypothetical guideline.
Introduction
If you’ve ever had an appliance break down at exactly the wrong time or had an unexpected car repair strike without warning then you understand the importance of liquidity. Liquidity is the ability to have cash on hand, or financial instruments that you can quickly and easily convert to cash without having them lose their value, in order to meet expenses.
A household may have enough money to meet its monthly expenses, but if there is not enough money left over, they are in danger of facing a crisis if, and when, an unplanned expense crops up. It’s the same in a macro sense with a business. A business has different ways to count current assets and current liabilities, but they all focus on the same idea – having enough profit (the difference between assets and liabilities) to not only pay their debt obligations but also to have reserves that can be deployed for other purposes. This relationship between a company’s current assets and current liabilities is known as a liquidity ratio.
As an investor, understanding a company's liquidity ratio is one of the fundamental ways to assess their financial health. One of the simplest liquidity ratios to calculate is the quick ratio. In this article, we'll review what the quick ratio is and explain how it is similar to, yet different from, the current ratio. We'll also go over the limitations to the quick ratio – which is essentially the same for any sort of liquidity ratio.
What is the quick ratio?
The quick ratio (also known as the acid-test ratio) is a liquidity ratio that can be used as a stand-alone metric of liquidity or used to refine the current ratio. The quick ratio measures a company's ability to pay off their short-term debts as they come due using their current assets minus inventory and prepaid expenses. These assets which include cash, short-term investments, and accounts receivable are considered to be the most liquid of current assets.
To calculate the current ratio of a business, an investor simply needs to look at a company’s balance sheet. Current assets are generally listed separately from long-term assets, and current liabilities are listed separately from long-term liabilities. If a company’s current assets are equal to its current liabilities, they would have a current ratio of 1.
The quick ratio is a more conservative ratio because it strips away items like inventory which may be hard to convert into cash should the company need to liquidate them quickly to cover expenses. In this way, some investors find the quick ratio more predictive of a company’s current financial health.
As an example, as of October 2018, Lowe’s Companies Inc. (NYSE: LOW) had a current ratio of 1.0 and a quick ratio of 0.18. At those levels, an investor would have to be slightly concerned about the company’s ability to pay back its current liabilities, assuming they all came due at one time.
How to find the components of the quick ratio
Investors can find a listing of current assets and current liabilities on a company’s balance sheet. This is one of several financial statements that a company is responsible for filing with the SEC as part of their regular earnings reports. Assets (which can also be found on a company’s income statement) are listed from top to bottom in order of their liquidity. So cash and cash equivalents will always be the top line followed by marketable securities, accounts receivable, inventory, and prepaid expenses. For the purposes of the quick ratio, all assets would be included except for inventory and prepaid expenses.
The liabilities on a balance sheet list the money that a company owes. Like assets, liabilities are usually broken down into current and long-term liabilities. For the quick ratio, an investor is only concerned with current liabilities, which might include things like any portion of long-term debt that the company will have to repay in 12 months. This means that if a company had a five-year, $10,000 loan, they would separate the loan payments they are required to make during the next 12 months as a current liability and push the rest out as a long-term liability. Other current liabilities would include money a company owes to a bank (bank indebtedness), interest payable, rent payments, taxes, utilities, payroll, prepayments to customers, and scheduled dividend payments.
Let’s look at this sample balance sheet from Starbucks Company (NYSE: SBUX) as of September 2018 (all values in 000’s)
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CURRENT ASSETS
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Cash & Cash Equivalents
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8,756,300
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Short-Term Investments (Marketable Securities)
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181,500
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Accounts Receivable – Trade, Net
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693,100
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Inventory
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1,400,500
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Other Current Assets
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1,462,800
|
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Total Current Assets
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12,494,200
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|
|
|
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CURRENT LIABILITIES
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|
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Accounts Payable
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3,691,400
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Short-Term Debt/Current Portion of Long-Term Debt
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349,900
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Other Current Liabilities
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1,642,900
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Total Current Liabilities
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5,684,200
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For this balance sheet, the current ratio would be:
Current Assets (12,494,200)/Current Liabilities (5,684,200) = 2.19
Their quick ratio would be:
12,494,200 – (1,400,500 + 1,462,800)/5,684,200
12,494,200 – 2,863,300/5,684,200
9,630,900/5,684,200 = 1.69
In this example, by either measure, the company is showing sufficient ability to meet its current debts.
Limitations of the quick ratio
- Ratios are about worst-case scenarios - In the real world, just as with your personal finances, bills come due at different times. This can allow us to pay bills at a time that corresponds to our having the funds to pay them. It’s the same with business. However, when a company has a ratio of 1.0 or lower, it can be an indication that there are cash-flow problems. The question that investors will need to ask is whether those problems are short-term or long-term. For example, a historical look at Lowe’s shows their median quick ratio over the last 13 years is 0.26. Since the industry median quick ratio is 0.94, investors will want to look at other metrics to either confirm or refute any negative sentiment they feel regarding Lowe’s.
- Ratios are snapshots of a current situation – For investors to make a fair analysis of what is going on in a company, they will need to look at several quarters and/or years of ratios to detect any trends. If they are noticing large swings in a ratio from quarter to quarter it may be an indication of industry volatility. If the number is consistently going up or down, it could be an indicator of a situation that bears further research.
- A comparison can be tricky- One of the uses of quick ratios is when comparing one business to another. However, different companies have differing inventory requirements. To ensure an apples-to-apples comparison look for two companies in the same sector. For example, the quick ratio of Home Depot (NYSE: HD) in the same time period as Lowe’s (October 2018) was 0.28 with a 13-year median of 0.41. When viewed in this context, the picture for Lowe’s looks more in line with the industry average. In this case, it can be reasonably assumed that both companies have a high percentage of their current assets tied up in inventory. But since that seems to be the industry norm, it may be less concerning.
Is the quick ratio better than the current ratio?
It really depends on what an investor wants to know. A quick ratio gets to the heart of liquidity faster because it strips away inventory which may be difficult to sell for cash. On the other hand, if a company is very reliant on inventory, such as a supermarket, removing inventory will not provide a realistic picture. Investors should look at all ratios available to them and compare those ratios with companies in the same industry to determine if a low or high number is an outlier for that company or closer to an industry average.
The final work on quick ratio
The quick ratio is the conservative sibling of the current ratio. Both ratios, along with the cash ratio are important liquidity ratios that investors can use to determine if a company has enough cash on hand to meet its short-term obligations. The generally accepted standard for determining if an asset is current or not is whether or not will be received, or have to be paid, in 12 months. A list of current assets and current liabilities can be found on a company’s balance sheet – which is one of the financial documents they are responsible for providing as part of their earnings report.
The fundamental difference between the quick ratio and the current ratio is that the quick ratio strips away inventory which can be difficult for a business to convert to cash quickly. This is why many investors prefer the quick ratio (which is also known as the acid-test ratio) as a way of determining the overall liquidity of a company.
Like the current ratio, the quick ratio has its limitations. The most common is that it needs to be looked at in light of historical trends, makes assumptions that may not be true of current business conditions, and – when doing comparisons – must be done with an eye towards looking at companies in the same industry.
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