The quick ratio, also commonly referred to as the acid test ratio, is among the financial ratios typically used to assess a business’s overall short-term liquidity. It evaluates a company’s ability to pay their debts using the most liquid assets. These are quick assets that can easily be changed into cash within 90 days. Therefore, the acid test formula represents a short-term investment, cash, and current receivables less prepayment dividends and inventory divided by the current liabilities.
A company with adequate cash and cash equivalent can settle its current liabilities. Creditors will also have the assurance of getting paid. The company will be able to settle all its current liabilities without selling its long-term assets.
Such companies will also attract more investors due to high liquidity levels and the probability of growing profitable in the future.
The Difference Between the Quick Ratio and the Current Asset Ratio
The current ratio is the ability of a business’s current assets to pay off the current liabilities. In contrast, the quick ratio measures the ability to settles current liabilities using the most liquid asset.
The current ratio is suitable for evaluating all business, whereas an acid test is suitable for a substantial inventory amount.
Quick Ratio Formula
Calculating the quick ratio:
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
The ideal quick ratio is considered to be 1. If the ratio falls below one, a company cannot fully pay its currents liabilities. A quick ratio of 2 means the company has $2 in quick assets at present to pay for each $1 of current liabilities.
Interpreting the Results
A decreasing or low acid test ratio shows that the company pays its bills too quickly, under pressure to grow or maintain sales, over-leveraged, or collecting accounts receivables too slowly.
An increase or high ratio shows that a business has a faster cash conversion cycle or inventory turnover. It usually occurs when a company is quickly converting accounts receivables into cash, experiencing rapid growth, and meeting its financial liabilities.
Also, a quick ratio that’s too high is not suitable for the company. This means the business has excess cash at hand that is not put into fair use. It could also mean the company has poor credit policies if the ratio is high due to too many accounts receivables.
Improving the Quick Ratio
Improve the time for the collection of accounts receivable. All debtors must have clear information concerning debt collection. The collection policies must reduce the time for collection. The acid test will then improve since the bad debts will be reduced as cash flow increases.
Settle accounts owed quickly. A business must keep its liabilities under control. If the current liabilities are kept below the current assets, the acid test ratio improves. Current liabilities can also be reduced by paying off suppliers, creditors, prepaid expenses and reducing the terms of loan payment.
Increase inventory turnover. Inventory turnover can be improved by increasing the number of cash sales. This will result in increased cash in hand for the business.
The Importance of the Quick Ratio
- It assists in helping evaluate the balance sheet and financial condition of a company.
- It gives an accurate picture of the company’s liquidity.
- It helps the companies to monitor their collection system.
- Investors can choose the right company to invest in depending on the acid test ratio.
Disadvantages of Quick Ratio
- The formula assumes all the current assets belonging to a business will be liquidated to meet its short-term liabilities. This is not the case since the business needs to maintain its operations using the working capital.
- The formula also assumes that the accounts are easily converted into cash, which may not be the case in the real world.
- It isn’t possible to know the level and timing of cash flow using the acid test ratio. Cash flows are essential for any business when it comes to settling debts.
- The quick ratio does not consider the inventory since it is regarded as an asset challenging to convert into cash. This isn’t always the case as some businesses can easily convert their inventory into cash with the current market price.
- In case the inventory for such business is ignored, it may lead to erroneous results and unnecessary panic, which may not reflect the situation.
- The liquidity of a company cannot be assessed single-handedly using the acid test ratio. Other ratios must also be put into consideration.
Allowance for debts, the timing of assets purchase, efforts to raise capital, and payment and collection policies will affect the quick ratio of various companies resulting in different results for similar companies. Also, the capital needs for companies from industry to industry affect the acid test ratio and a company’s ability short-term obligations.
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