Quick Ratio Definition - Formula - Importance - Example - Analysis
Quick Ration Definition
What is Quick Ratio?
Basically,
Quick Ratio shows how effectively a company can meet its short-term
obligations (Current Liabilities). How effectively a company is in the
Liquidity of its Current Assets. so this ratio is also called Liquidity Ratio. Also, Acid-Test Ratio and Working Capital Ratio are the other names of this ratio. This ratio represents
better presence of those Current Assets that are converted into cash
very quickly, so we deduct those assets from Current Assets that has less liquidity in nature. Here Liquidity means those assets that
converted into cash very quickly so we deduct Closing Inventory and
Prepaid Expenses From Current Assets in order to arrive More Liquid Current Assets or Quick Assets. Acid-Test Ratio includes Quick Assets that are Cash And Cash Equivalents (Marketable Securities, etc) and Accounts Receivable.
Investors
and Accounts Payable are interested in the Liquidity ratio of the
company in order to examine whether to invest or give credit to the
company or not.
Quick Ratio Formula
Quick Ratio is calculated by Dividing Quick Assets By Current Liabilities. Mathematically, we can written as shown below:
Quick Ratio = Quick Assets / Current Liabilities
Here Quick Assets = Cash + Cash Equivalents (Marketable Securities,etc) + Accounts Receivable
So, if we have Current Assets, then in order to calculate Quick Assets, we need to deduct the Closing Inventories + Prepaid Expenses From The Current Assets. Mathematically, we can written as shown below:
Quick Assets = Current Assets - (Closing Inventories + Prepaid Expenses)
Example:
Suppose, the company balance sheet shows Current Assets = 830000 that include Cash = Rs. 500000, Marketable Securities = Rs. 50000, Prepaid Expenses = Rs. 30000, Closing Inventory = Rs. 100000 and Accounts Receivable = Rs. 150000. Current Liabilities = Rs. 350000 Now To Calculate Quick Ration, we know that:
Quick Ratio = Quick Assets / Current Liabilities = 7000000 / 350000 = 2
Quick Assets = Current Assets - (Closing Inventory + Prepaid Expenses)
Quick Assets = 830000 - (100000 + 30000) = 830000 - 130000 = Rs. 700000
Analysis:
So,
the company is good in Liquidity and can attract Investors and Accounts
Receivable to invest or give credits to company because can give return
on investments or can pay the bills in time. If this ratio is 1.1, then
it means that the company is in break even point and meet just its current liabilities to run the business. But if it is 1:0.5, then it means
that the company is able to use the cash for investment purposes or
save it for future purposes or for buying the inventories. If it is 2:1,
then the company can easily meet its short-term obligations and can
also give credits to other companies or make investments or buy
inventories, etc.
Importance of Quick Ratio
1. By knowing the Quick Ratio, an investor is willing to invest in the company because this ratios
measure the efficiency of the company in converting the quick assets
into cash very quickly in other words it shows the liquidity of the
company. Similarly, accounts payable give credit reliably due to the
good Acid-Test Ratio because they are ensured that they will get their
payments in time.
2.
If this ratio is good, which depends upon particular type of industry in which a business is running, then it shows that the working capital of the
company is good to meet daily expenses of the business. e.g pay bills, telephone charges, petty cash payments, etc.
3.
This ratio shows real liquidity ratio unlike Current Ratio, because we
deduct Closing Inventory and Prepaid Expenses from Current Assets.
So, we can say that Quick
Ratio is very important for measuring actual liquidity performance of
the company and the key factor in encouraging investors to invest in the
business of company or influence the Accounts Payable to give credit to
company because the company can pay the bills in time due to healthy
Liquidity Ratio in the business.
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