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## What Is the Quick Ratio?

The Quick Ratio, also referred to as Acid Test Ratio and Liquidity Ratio measures the ability of a company to settle current liabilities through their most liquid assets which are Cash, Accounts Receivable, and Marketable Securities.

The term Acid Test is actually derived from how quick assets can be converted to cash, like an acid test that generates fast results.

The reason why other than Cash and Cash Equivalents, Accounts Receivable and Marketable Securities are considered as Liquid assets is that Accounts Receivable can be collected from the customers with just short notice.

Marketable Securities, on the other hand, can be sold easily through a broker.

## Understanding the Quick Ratio

Quick Ratio deals with two classifications of accounts in the Balance Sheet: Liquid Assets and Current Liabilities.

The Liquid Assets do not include inventory although it is a current asset because selling it can be quite difficult and oftentimes, it will be at a loss.

Current Liabilities refer to the liabilities owed by the company that need to be settled within a year.

A healthy Quick Ratio would be if the Liquid Assets can match each dollar of Current Liabilities.

This means that a Quick Ratio of 1 means that the company can settle its Current Liabilities.

However, if the Quick Ratio is less than 1, they may not be fully equipped to meet current obligations.

For example, a company computed that they have a quick ratio of 2.

For every dollar of current liability, they have \$2 available to pay off each dollar.

Although a Quick Ratio offers valuable insight in terms of the liquidity of a company, this should not be the sole basis of interpretation of its financial data.

There are other financial ratios and analyses that can help management make better financial decisions and assess a company’s overall financial health.

## The formula for the Quick Ratio

To compute for the Quick Ratio, the following formulas can be used:

### Current Ratio Formula

The accounts needed to compute for the Quick Ratio are easily available on the Balance Sheet.

However, when Accounts Receivable is computed, what should only be considered are the balances that can be collected within 90 days.

## Example of Quick Ratio

ABC Company and XYZ Corporation presented the following data from their Balance Sheet to compute for their Quick Ratio:

 Account Head ABC Company XYZ Corporation Cash & Cash Equivalents \$425,000 \$145,000 Accounts Receivable \$170,000 \$200,000 Marketable Securities \$300,000 \$90,000 Current Liabilities \$1,200,000 \$330,000

Based on the data above, the Quick Ratios of ABC Company and XYZ Corporation can be computed as follows:

ABC Company: (\$425,000 + \$170,000 + \$300,000) / \$1,200,000 = 0.75

XYZ Corporation: (\$145,000 + \$200,000 + \$90,000) / \$330,000 = 1.32

Even though XYZ Corporation have lesser liquid assets in total and lesser liabilities, it has a higher quick ratio and is better positioned to pay off their current liabilities with the liquid assets that it holds.

## Quick Ratio vs. Current Ratio

A more accurate financial measure in terms of a company’s liquidity is the Quick Ratio because it involves Inventory and Prepaid Expenses which are two accounts that cannot be easily converted to cash within a short period.

The Current Ratio, on the other hand, includes both of these accounts.

Inventories will take time to sell – even at a discount.

When it comes to Prepaid Expenses, they can’t be used to pay for Current Liabilities.

They must be excluded in the computation.

## What Happens if the Quick Ratio Indicates a Firm is Not Liquid?

Liquidity is an important indication of a company’s financial health.

But even with healthy companies, when the liquid assets are not enough to cover the short-term obligations of a company, there arises a liquidity crisis.

When this happens, paying suppliers, employee payroll, and debts can be a challenge.

With a falling Quick Ratio, securing debt from financing companies can be difficult and the only remedy available to them would be to file for bankruptcy or sell their assets.

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1. Everett Community College "Financial Ratios " Page 1 - 3. March 28, 2022

2. Webster University "Financial Ratios" Page 1 . March 28, 2022