Quick Ratio

What is Quick Ratio

The quick ratio is sometimes referred to as the"acid test” (yes, this is a reference to a chemistry name). This relative valuation metric indicates a company's liquidity. It measures how well a company's current assets can pay its short-term debt.

Generally speaking, when comparing the quick ratio between similar companies, the higher the quick ratio, the better the company's liquidity and the more healthy a company is. If the ratio is low, then the company will very like to struggle with paying back the debt, which indicates a risk for investors.

However, high quick ratios are not always good. An overly-high quick ratio might indicate that the company is not using the best value of its asset. In finance, debt is not always a bad thing, since it is an essential source of financing for many companies. So if a company has only a few debts compared to all of its assets, this might suggest an inefficient use of its asset. Overall, balance is the key when it comes to debts.

Calculation

The calculation of the quick ratio is as follows:

The formula compares the current assets (assets that can be easily liquidated) with current liabilities (AKA short-term debts).

• Quick Ratio = (Cash, Cash Equivalent + Market Securities + Account Recievables) ÷ (Current Liabilities)

How to Apply?

The quick ratio itself does not contain much value. In fact, it only works when compared with similar companies, such as companies with similar business structures or under the same industries. The reason is that in different industries, companies will have different asset and capital structures, thus making the average quick ratio varies according to the industry.