Quick Ratio Analysis

In the postings Necessity of Working Capital and The Current Ratio Matters we looked at the importance of having adequate working capital and a couple of ways of assessing a company’s working positions. In addition to the actual dollar amount of working capital and the current ratio, there is another liquidity measure, the Quick Ratio.

Quick Ratio

The quick ratio analysis is a way to look at liquidity that is a little more stringent in what are considered liquid assets. Unlike the current ratio that includes all current assets in the calculation of the ratio, the quick ratio only includes cash, marketable securities and accounts receivable. This assumes that the accounts receivable included in this calculation are collectible, which may or may not be true. Regardless, it is probably a more realistic picture of liquidity than the current ratio, which also includes inventory. As you probably know, inventory is not always that easy to convert to cash in a timely manner, particularly if your company is overstocked or has obsolete items in inventory.

Some Examples

Like we did we working capital and the current ratio, let’s look at some examples.

quick ratio

Notice that the quick ratio is frequently considerable lower than the current ratio. Example one shows a company, with a quick ratio of 1.31 that appears to have more liquid assets than needed to cover current liabilities. In example two the quick ratio of 1.00 indicates that this company also should be able to meet obligations for current liabilities, although it is somewhat less certain. Example three is a company whose quick ratio of .53 shows questionable ability to pay current obligations as due. The company really needs to be diligent in managing assets and liabilities and may require an influx of capital to keep operating. These three examples demonstrate how a quick ratio analysis can alert you to possible liquidity problems. By tracking this on a regular basis you may be able to take corrective action before a crisis occurs.

So What Does This All Mean?

Liquidity is crucial. In the examples above we considered only the current assets that are considered highly liquid. However, just as with the current ratio, we have not considered the collectability of accounts receivable or the impact of near-term obligations (like payroll) that will need to be paid and are not already reflected in the current liabilities. Consider these when using the quick ratio to estimate financial strength.

Do you have a clear understanding of why a quick ratio analysis is a helpful financial indicator? For assistance with this calculation and corrective steps you can take, please contact AimCFO.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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