The Quick Ratio is an indicator of a company's short-term liquidity and measures a company's ability to meet its short-term obligations with the most liquid assets. Quick Ratio demonstrates the ability of the company to immediately use assets close to cash (assets that can be quickly converted to cash) to pay off its existing liabilities.
- Quick Ratio shows a company's ability to pay off short-term debts without selling inventory or receiving additional financing
- Quick Ratio is considered a more prudent measure than the current ratio, including all current assets to compensate for short-term debts.
- The higher this ratio results, the better the company's liquidity and financial health;
- The lower this ratio, the more the company struggles with debt repayment.
Quick Ratio Definition
The quick ratio measures the dollar amount of current assets versus the dollar amount of a company's short-term liabilities. Working assets are assets that can be quickly converted to money with minimal impact on open market prices, while short-term liabilities are debts or corporate obligations that are due to be paid to creditors in the market. within a year.
The result of 1 is considered the usual fast ratio. It shows that the public has enough assets that can be immediately liquidated to pay off short-term liabilities. A company with a quick ratio of less than 1 may not be able to pay off its short-term liabilities in the short term, while a company with a quick ratio higher than 1 may be able to get rid of the payments immediately. Short-term debt. For example, a quick ratio of 1.5 indicates that a company has $ 1.50 worth of current assets available to cover each $ 1 of its short-term debt.
However, numbers like these cannot help but provide a full picture of the overall state of the business. It is important to consider other relevant measures to assess the true situation
Quick Ratio Formula
Quick Ratio = (CE+MS+AR)/CL
Quick Ratio = (CA – I – PE)/CL
CE = Cash and Equivalents
MS = Marketable securities
AR = Accounts receivable
CL = Current Liabilities
CA = Current Assets
I = Inventory
PE = Prepaid expenses
To calculate the quick ratio, locate each formula element on your company's balance sheet under the working assets and current liabilities section.
While calculating the quick ratio, double-check the ingredients you are using in the formula. The numerator of liquid assets must include assets that can easily be converted to cash in the short term (within 90 days or longer) without affecting their price. The inventory does not count towards the quick ratio because many companies, to sell out their inventory within 90 days or less, will have to apply a high discount to encourage customers to buy quickly. Inventories include raw materials, components, and finished products.
Please note that only accounts receivable that may be collected within 90 days should be considered. Receivables are amounts owed by the company to customers for goods or services delivered.
Customer Payment Impact on the Quick Ratio
A business can have as much money as accounts receivable, which can increase the quick ratio of payments. However, if payment from a customer is delayed due to unavoidable circumstances, or if the payment has a too long due date, such as 120 days based on terms of sale, the company has can not be met. This can include essential business expenses and immediate liabilities. Although the business has good revenues, the actual quick ratio may be too low and the business may run the risk of running out of cash.
On the other hand, a company can negotiate the quick payment from customers and ensure longer payment terms from its suppliers, which will keep liabilities on the book for long. than. By converting accounts receivable into cash faster, it can have a better quick ratio and be fully equipped to pay off short-term liabilities.
Whether accounts receivable are a quick source of cash is still a controversial subject, and depends on the terms of credit the company offers to its customers. A company that needs to pay in advance or only allows customers to pay in 30 days will have better liquidity than a company offering 90 days. Also, the credit terms of a company to its suppliers affect its liquidity position. If a company gives its clients 60 days to pay but has 120 days to pay its suppliers, that company's liquidity position is good as long as its receivables match or exceed accounts payable.
Two other components: cash and market stock, often so timeless. However, to maintain calculation accuracy, one should only consider amounts received for 90 days or less under normal conditions. Early liquidation or premature withdrawal of assets such as securities may result in penalties
How Do the Current Ratio and Quick Ratio Differ?
Quick Ratio is more cautious than the Current Ratio because it does not include inventories and other movable assets, which are often harder to convert into cash. The quick ratio only looks at assets that can be converted into cash very quickly. The current ratio, on the other hand, considers inventory and asset upfront cost. In most companies, inventory takes time to liquidate, although some rare companies can move their inventory fast enough to treat it as an asset quickly. Upfront costs, although an asset, cannot be used to pay off short-term liabilities, so they are ignored in the quick ratio.
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