The quick ratio measures a company’s ability to cover its current liabilities with cash or near-cash assets.
Many entrepreneurs launch a startup based on an innovative business idea, but they quickly encounter a mess of complex accounting terms that are tough to understand, let alone calculate. Small business owners have a lot of responsibilities on their plates, with little spare time to crunch numbers and run tests. If you’re feeling overwhelmed, you might be wondering: Which accounting ratios matter and why?
The quick ratio (acid test) formula is worth learning, no matter your industry. You should always know how fast your business can pay back its debts, especially during uncertain economic conditions. Keep the quick ratio formula in your back pocket. You can use it to monitor your liquidity so that you’re always prepared if problems arise and lenders come knocking.
We’ll explain how to calculate the quick ratio and provide context as to how this liquidity test can shed light on your company’s financial wellbeing.
What is the quick ratio formula?
In accounting, the quick ratio is a liquidity test. The test measures a company’s ability to pay back its bills with business assets that may readily convert to cash. The formula subtracts inventory from a company’s current assets then divides that figure by the number of its current liabilities.
What is a liquidity ratio?
Liquidity ratios analyse a company’s ability to fulfill its debts. As a small business owner, tracking liquidity is important because it’s your responsibility to ensure the company can follow through on its financial commitments. Lenders also use the ratio to track liquidity when assessing a company’s creditworthiness. If you lack sufficient cash flow, lenders may see you as a risk, making it harder for you to obtain credit.
Compared to the current ratio and the operating cash flow (OCF) ratio, the quick ratio provides a more conservative metric. Generally, the higher the ratio, the better the liquidity position. A perfect quick ratio is 1:1, meaning an organisation has $1 in current assets for every $1 in the company’s current liabilities.
What happens when the quick ratio is less than one?
A quick ratio that’s less than one likely indicates the company does not have enough assets to cover its debts. If the quick ratio is significantly low, the business may be heavily dependent on inventory that can take time to liquidate.
A high quick ratio (a quick ratio higher than one) might mean you have too many resources tied up in cash. Cash can lose purchasing power due to inflation. That’s money sitting in a bank account that you could spend on the business.
Ultimately, the ideal liquidity ratio for your small business will balance a comfortable cash reserve with efficient working capital. Startups are wise to keep more cushion on hand, while established businesses can lean on accounts receivable more.
What is an acid test ratio?
You can use the terms “acid test ratio” and “quick ratio” interchangeably. The name comes from a historical reference to early miners who used acid to determine whether a metal was gold. If the metal passed, it was pure, but if it failed, it was rendered valueless.
Today, accountants use the acid test to show how well a company can pay off its total current liabilities using only quick assets, not current assets.
What are current assets?
Current assets include all of a company’s assets that it can reasonably expect to sell or use within a year without losing value. Non current assets, such as land and goodwill, are long-term assets because their full value will not be recognised within an annual accounting cycle.
A company’s current assets might include cash and cash equivalents, accounts receivable, marketable securities, prepaid liabilities and stock inventory.
Cash and cash equivalents
Cash is your most liquid asset. This line item includes all paper bills, coins, cheques and money orders your business has on hand. Cash equivalents (CE)—such as stock market funds and business bank accounts—are mostly liquid. Many business owners store cash equivalents in interest-earning accounts to make their money work harder for them in savings. In this case, business owners retain the ability to access liquid funds quickly.
You may not receive full payment in cash or credit at the point of sale. When you sell goods or services on credit, record the revenue in your accounts receivable (AR). AR represents the value of outstanding money owed to your business. It’s important to note, however, that receivables can only qualify as current assets if customers pay for them within your business’s operating cycle.
Be diligent with outstanding payment collection. You’ll want to ensure your quick ratio formula is accurate and you’re not inflating your assets with delinquent accounts. Otherwise, you may find yourself facing cash flow problems if a late paying customer impedes your ability to pay your bills.
Shares and government bonds are some of the most common types of marketable securities. Also known as short-term investments, securities can easily liquidate and convert to cash within an operating cycle. Their value can fluctuate, depending on interest rates and market volatility, so record their current market value in your balance sheet.
If your business has prepaid expenses for future goods or services, like leased equipment or legal retainer fees, their value counts towards current assets. The value counts as long as the prepaid benefit has not expired, and the expense falls within the operating cycle.
Finally, inventory accounts for all assets you intend to sell and any raw materials you need for manufacturing. Tally up the value of all goods in production plus finished goods ready for sale, then add that figure to the expenses you paid for materials. You might have to calculate how much it costs your company to keep that item in stock. If you have to pay for shipping, storage or associated charges, subtract those costs from the total inventory value.
What are quick assets?
Quick assets are current assets that can be converted to cash within 90 days. Generally, quick assets include cash, cash equivalents, receivables and securities. If your balance sheet lacks a breakdown of your company’s quick assets, you can determine their value. Subtract your existing inventories from current assets and any prepaid liabilities that carry no liquidity.
Subtracting inventory can dramatically reduce the value of a company’s current assets. Because of that, some lenders believe the current ratio provides a more accurate measure of overall worth. However, there’s no guarantee when (or if) shares will sell and at what price. The quick ratio formula is about determining if you can cover current liabilities by liquidating quick assets into cash.
What are current liabilities?
Current liabilities represent financial obligations a company owes to another party that are due within a year. Non-current debt is due at a later time.
Hopefully, you’ve been meticulously recording your company’s open lines of credit and unpaid invoices. Common examples of current liabilities include loans, interest, taxes, accounts payable, services and products. Confirm that you’ve accounted for each in the quick ratio formula.
Most entrepreneurs take out small business loans to launch their startups. It’s rare to have all of the capital on hand to get operations up and running. You might obtain funds through small business government grants and subsidies, a venture capitalist, an angel investor, a crowd-funding campaign, family or friends. In every case, account for every cent of debt you owe.
Most loans charge interest on top of the principal balance, so you’ll need to calculate those costs into your current liabilities. For example, let’s say you took out a $5,000 loan with 3% interest that becomes due and payable by the end of the year. You’ll need to include the additional $150 into the quick ratio formula for accurate metrics.
Mismanaged taxes can result in late fees and penalties to the business from the tax office. Calculate all the estimated quarterly taxes and employee payroll taxes you may be responsible for. You need to be sure you can cover your federal and state tax obligations. The quick ratio formula can prevent you from being caught off-guard by a bill you can’t afford.
Accounts payable (AP), also known as trade payables, reflects how much you owe suppliers and vendors for purchases on credit. It also includes your obligation to repay a short-term debt—such as a business expense card—to creditors.
You may have outstanding service charges—from financial institutions or another third party—that do not fall into your accounts payable. Remember to also account for deferred revenues or money you’ve collected for services you haven’t delivered when calculating the quick ratio formula.
Products that customers have prepaid for also fall within your deferred revenues. You should consider them a current liability until you deliver the item. In most B2B sales, you enter the items for which your business remains liable as accounts payable line items. However, you might need to set aside funds to cover customer product warranties, depending on your offering and return policy.
How does the quick ratio work?
Let’s look at an example of the quick ratio in action to understand how it works and what the formula can reveal.
For this example, let’s say a company owns $250,000 in current assets, $50,000 in inventory and $100,000 in liabilities. After subtracting $50,000 from current assets, we find the company’s quick asset value is $200,000. Essentially, the company can easily liquidate $200,000 to cover the $100,000 in liabilities that it has to pay this year. The company’s quick ratio is 2:1, so the business has $2 in current assets to pay for every $1 in current liabilities.
Why is the quick ratio formula important?
The quick ratio helps determine a company’s short-term solvency. Essentially, it’s the company’s ability to pay debts due in the near future with assets that can quickly be converted to cash. This type of short-term liquidity is extremely crucial to startups for a few reasons.
- Small businesses are often prone to unexpected financial hits that can disrupt cash flow. If there’s a cash shortage, you may have to dig into your personal funds to ensure you pay employees, lenders, and bills on time. In 2020, QuickBooks found that nearly half of small business owners surveyed have used personal funds to keep their businesses running.
- If you don’t have funds to cover your company’s financial obligations, you might have to take out a short-term emergency loan. In many cases, these loans come with higher interest rates and may increase your company’s financial risks. These loans can also affect your personal credit score.
- Using the quick ratio, you can stay on top of your finances and keep tabs on how much of a cushion your business needs. A safety net can help keep you afloat even when external factors cause a dip in revenue. These days, many business owners are experiencing cash flow problems as a result of the coronavirus pandemic.
- Gauging liquidity levels can help you make more informed financial decisions. You can gain a deeper perspective on business decisions. For example, it can help you decide when to purchase new equipment. If you don’t have the liquidity, you might play it safe and wait for higher liquidity to cover your bases.
- If you adjust your cash flow to optimise your company’s quick ratio, you can settle your current liabilities without selling any long-term assets. Long-term assets are often valuable sources of generated revenue. Selling these assets can hurt your company, and it can indicate to investors that your current operations aren’t turning enough profit.
- Suppose you want to expand operations and acquire more funding. The quick ratio formula can help demonstrate your company’s high level of liquidity. Higher liquidity means lenders may be less likely to decline your loan.
The quick ratio is one of several accounting formulas small business owners can use to understand their company’s liquidity position. They can also use it to monitor financial health and strategise future growth opportunities.
It’s easy to calculate the quick ratio formula and run financial reports with QuickBooks accounting software. Our cloud based system tracks all your financial information and gives you fast access to your total current assets and liabilities. You can spend less time running the numbers and more time driving success.