What is the Quick Ratio?

The quick ratio is used to evaluate whether a business has enough liquid assets that can be converted into cash to pay its bills. The key elements of current assets that are included in the ratio are cash, marketable securities, and accounts receivable. Inventory is not included in the ratio, since it can be quite difficult to sell off in the short term, and possibly at a loss. Because of the exclusion of inventory from the formula, the quick ratio is a better indicator than the current ratio of the ability of a company to pay its immediate obligations. This is a particularly useful ratio when a business is facing difficult financial circumstances, and needs to pay off a substantial amount of liabilities in the near term.

Related AccountingTools Courses

Business Ratios Guidebook

The Interpretation of Financial Statements

How to Calculate the Quick Ratio

To calculate the quick ratio, summarize the totals for cash, marketable securities and trade receivables, and divide by current liabilities. Do not include in the numerator any excessively old receivables that are not likely to be paid, such as anything over 90 days old. The formula is:

(Cash + Marketable securities + Accounts receivable) ÷ Current liabilities = Quick ratio

The information needed for this calculation can be found on the balance sheet. An analysis of excessively old accounts receivable can be found on a company’s accounts receivable aging report.

What is Included in the Quick Ratio?

As just noted, the quick ratio is determined by dividing certain current assets by selected current liabilities. Current assets are all assets expected to be liquidated within one year, while current liabilities are all obligations expected to be settled within one year. The accounts most commonly included in the current assets classification that are also part of the quick ratio calculation are as follows:

Cash. This includes the amounts currently held in checking and savings accounts.
Marketable securities. This includes all securities held for investment purposes, such as stocks and bonds.
Accounts receivable. This includes all trade receivables and other receivables. Trade receivables are amounts owed to the business by its customers. Other receivables are usually amounts owed to the company by its employees and other parties.

The accounts most commonly included in the current liabilities classification that are also part of the quick ratio calculation are as follows:

Accounts payable. This includes all trade payables and other payables. Trade payables are amounts owed by the business to its suppliers. Other payables may be amounts owed to related parties or employees, or to parties considered to be outside of the normal course of business.
Accrued liabilities. This includes all obligations by the business for which suppliers have not yet issued an invoice. This can be a large amount if a business closes its books quickly at the end of the month, and records accruals rather than waiting for month-end supplier invoices to arrive.
Short-term debt. This is that portion of company debts that are due for payment within the next 12 months.

Understanding the Quick Ratio

Despite the absence of inventory from the calculation, the quick ratio may still not yield a good view of immediate liquidity, if current liabilities are payable right now, while receipts from receivables are not expected for several more weeks. This can be a particular concern when a business has granted its customers long payment terms.

The ratio is most useful in manufacturing, retail, and distribution environments where inventory can comprise a large part of current assets. It is particularly useful from the perspective of a potential creditor or lender that wants to see if a credit applicant will be able to pay in a timely manner, if at all.

If a quick ratio calculation indicates a low level of liquidity, a business will need to derive alternative sources of cash to ensure that it can meet its immediate obligations. This can be done through accounts receivable financing, a line of credit, some other type of asset-based financing, or the sale of shares in the business. If it is not possible to obtain such financing, then there is a good chance that the entity will be forced into bankruptcy.

Which Assets Have the Highest Liquidity?

The assets with the highest liquidity are cash and cash equivalents, since they can be readily sold off for their full value. Marketable securities have the next-highest level of liquidity, since they can usually be converted to cash within one business day. Accounts receivable can take longer to convert to cash, perhaps requiring one or two months for this to be completed (depending on the payment terms). A further concern with receivables is the unpredictability of their collection. Some customers may pay on time, while other customers may pay much later, depending on their ability to pay and any issues with the goods or services delivered to them that require resolution. This unpredictability is not associated with cash equivalents or marketable securities.

Quick Ratio vs. Current Ratio

The current ratio is the same at the quick ratio, except that the current ratio includes inventory and prepaid expenses in the numerator. This difference is critical, since inventory can be a difficult asset to liquidate; in many cases, it may be impossible to sell off on short notice without offering buyers a significant discount from the inventory list price. This difference is not an issue for services businesses, which rarely need to maintain much inventory. Prepaid expenses are excluded from the quick ratio, since this line item represents expenditures that have already been made; therefore, prepaid expenses cannot be liquidated to pay for any current liabilities.

Example of the Quick Ratio

Rapunzel Hair Products appears to have a respectable current ratio of 4:1. However, the breakdown of the components of its current assets tell a different story. The components are noted below, along with both the current ratio and quick ratio.

Account
Amount

Cash
$100,000

Marketable   securities
$50,000

Accounts receivable
$420,000

Inventory
$3,430,000

Current liabilities
$1,000,000

Current ratio
4:1

Quick ratio
0.57:1

The component breakdown reveals that nearly all of Rapunzel's current assets are in the inventory area, where short-term liquidity is questionable. If the company cannot sell off its inventory in short order, it may not be able to meet its immediate obligations. This issue is only visible when the quick ratio is substituted for the current ratio.