A quick ratio is a number that tells you how easily a company would be able to pay its short term liabilities using liquid assets. It’s also known as an ‘acid test ratio’.
A quick ratio is expressed as a single number. This number tells you how much a company has in assets relative to its liabilities.
A quick ratio of 1 would mean that a company has £1 for every £1 it owes in short term liabilities. That would mean it has exactly the amount required to pay those short-term liabilities.
A quick ratio of 0.5 would mean that a company only has £0.50 in assets for every £1 it owes in short-term liabilities, meaning it would not have enough to meet its short-term liabilities.
Similarly, A quick ratio of 2 would mean that a company has £2 in assets for every £1 it owes in short-term liabilities, meaning it would have more than enough to meet its short-term liabilities.
Quick ratios are useful to investors because they allow them to see how healthy a company’s finances are. A quick ratio which indicates a business will be more than capable of paying any money it owes could be in a better position than one that cannot.
Quick ratios and liquid assets
Almost every company has liabilities - money that it owes. Those could be debts to a bank or the rent a firm has to pay each month for its office.
Similarly, almost every company will have some assets. Those are the things that it owns. Assets could include real estate, computers or simply cash held in a bank account.
The potential problem here is that you may have valuable assets that you can’t use to pay your liabilities. For instance, a company might owe its bank £1 million but it’s very unlikely that they’ll be able to pay that money using a piece of real estate worth £1 million.
A quick ratio looks at the assets a company has and measures how easy that company would find it to pay off its short-term liabilities. Because the assets have to be used to pay liabilities, the ratio only takes into account those assets which can easily be turned into cash. Such assets are usually known as ‘liquid assets’.
Calculating quick ratios
To calculate a quick ratio, you do have to use some simple maths. Here are the numbers you’ll need to start with.
Cash and cash equivalents - C
Marketable securities - MS
Accounts receivable - AR
Current liabilities - CL
Quick ratio = C+MS+AR CL
If you are wondering what marketable securities are, they’re simply tradeable assets, like stocks, which can be quickly converted into cash.
Accounts receivable refers to money that is owed to a company by its debtors. As there is a chance that these debts won’t be paid, some investors will not include them in their quick ratio formula.
