accounting

What is the quick ratio and how to calculate it?

The quick ratio formula is quick assets divided by current liabilities. It’s also known as the acid-test ratio and is worth learning—no matter your industry. The quick ratio helps you track your liquidity, which is your ability to pay bills in the short term. Using the quick ratio can help you avoid cash flow problems and maintain good relationships with your creditors and suppliers.

This article will explain how to calculate the quick ratio and provide tips on improving liquidity. Here’s what we’ll dive into:

The higher the quick ratio, the more financially stable a company tends to be, as you can use ‌the quick ratio for better business decision-making.

What is the quick ratio?

The quick ratio formula is a company's quick assets divided by its current liabilities. It’s a financial ratio measuring your ability to pay current liabilities with assets that quickly convert to cash.

Quick assets = cash + cash equivalents + marketable securities + accounts receivable

Quick assets are current assets that you can convert into cash within 90 days. Current liabilities are obligations due within 12 months.

Generally, the higher the ratio, the better the liquidity position. A quick ratio of 1.0 means that for every \$1 a company has in current liabilities, it also has \$1 in quick assets.

For example, if a company has \$1,000 in current liabilities on its balance sheet. But also has \$1,500 in quick assets, so its quick ratio is 1.5, or \$1,500 / \$1,000.

Quick ratio example

Let’s look at an example of the quick ratio in action to understand how it works and what the formula can reveal. Here’s an example of a company’s balance sheet that your accounting software could produce:

To calculate the quick ratio, we need the quick assets and current liabilities.

Quick assets from the example balance sheet are:

• Cash \$1,000
• Cash equivalents \$500
• Marketable securities \$1,300
• Accounts receivable \$1,600
• Total quick assets \$4,400

The current liabilities are:

• Accounts payable \$1,800
• Prepaid expenses \$600
• Short-term loans \$1,000
• Taxes payable \$600
• Total current liabilities \$4,000

The quick ratio in this example is 1.1, or \$4,400 / \$4,000. This means the business has \$1.10 in quick assets for every \$1 in current liabilities.

Components of the quick ratio

The quick ratio comprises quick assets and current liabilities. Quick assets are assets a company expects to convert to cash in 90 days or less. Current liabilities are obligations the company will need to pay within the next year.

Quick assets

Current assets are assets that can be converted to cash within a year or less. It includes quick assets and other assets that might take months to convert to cash. Such as inventory and prepaid expenses.

Quick assets include cash, cash equivalents, receivables, and securities, but will exclude inventory since it’s unclear when it will sell and at what price.

Cash, cash equivalents, and marketable securities are a company's most liquid assets. It includes anything convertible to cash almost immediately, such as bank balances and checks.

Marketable securities are short-term assets that can take a few days to turn into cash. Examples of marketable securities include stocks and money market funds.

Accounts receivable (A/R) is the money that customers owe you. These assets are less liquid than cash and marketable securities. But companies still expect to receive the money within 90 days.

Current liabilities

Current liabilities represent financial obligations due within a year. This can include unpaid invoices you owe and lines of credit you have balances on. Pretty much any payable you have will be a current liability.

Accounts payable, or trade payables, reflect how much you owe suppliers and vendors for purchases. Current liabilities will also include short-term debt. For example, if you have a five-year loan for a vehicle, the next 12 months of payments will be a current liability.

Current liabilities include:

• Accounts payable
• Salaries and wages payable
• Taxes payable
• Short-term debt

Quick ratio vs. current ratio

The quick ratio and current ratio are accounting formulas small business owners can use to understand liquidity. While the quick ratio uses quick assets, the current ratio uses current assets. Both use current liabilities. The current ratio formula is current assets divided by current liabilities.

Current ratio = current assets / current liabilities

A company can convert quick assets to cash in less than 90 days, while some current assets can take up to a year. The quick ratio is a more conservative measure of liquidity than the current ratio.

A company may have a higher current ratio, especially if it carries a lot of inventory. Note that quick assets exclude inventory.

But there are some downsides to the quick ratio. The quick ratio does not take into account the collectability of accounts receivables. It also ignores other sources of liquidity, such as credit lines.

Why is the quick ratio important?

Small businesses are 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 pay employees, lenders, and bills.

As a small business owner, tracking liquidity is important: It's your responsibility to ensure the company meets its financial commitments. Lenders also use the quick ratio to track liquidity when assessing creditworthiness.

The quick ratio is easy to calculate and can give you a quick snapshot of liquidity—it’s best for:

• Comparing: Quick ratios are useful when using industry standards or peers as a benchmark. This will give you a target to aim for.
• Decision-making: Liquidity levels can help you make better financial decisions. For example, it can help you decide when to buy new equipment. If you lack liquidity, you might play it safe and wait.
• Planning: If you adjust your cash flow to optimize your company’s quick ratio, you can cover your current liabilities without selling other assets.

What is a good quick ratio?

A quick ratio above 1.0 indicates a company has enough quick assets to cover its current liabilities. A higher ratio indicates that the company has more liquidity and financial flexibility.

Here’s a quick ratio guide for determining what is a good ratio:

• Less than 1: Unhealthy
• 1 to 1.5: Healthy
• 1.5 to 3: Very healthy
• Over 3: Questionable

A very high quick ratio, such as three or above, is not always a good thing. Such a high quick ratio means there’s too much cash in the bank. This means the company is missing growth opportunities.

Note that while a quick ratio of one is generally good, whether your ratio is good or bad will depend on your industry.

Due to different characteristics, some industries may have an average quick ratio that seems high or low.

A couple of examples of how quick ratios can vary include:

• A retail business may have a lower quick ratio than a service business. That's because retailers have more inventory and lower accounts receivables.
• A seasonal business may have a higher or lower quick ratio at different times of the year due to the fluctuations in its cash flow and liabilities.

It’s important to compare the quick ratio of a company with its peers. But also with your own historical performance. This will give you a better understanding of your liquidity and financial health.

The ideal liquidity ratio for your small business will balance a comfortable cash reserve with efficient working capital.

How do you improve your quick ratio

Making sure your business has enough liquidity means improving your quick ratio—there are three ways to do that:

1. Increase your cash: You do this by growing your sales or reducing expenses. While drawing from a credit line or taking a short-term loan will increase your cash, it also increases your current liabilities. Meaning it does not benefit your quick ratio.
2. Decrease your inventory: Inventory is one of the least liquid assets. But if you sell out-of-date inventory, it can boost your cash holdings—and your quick ratio. ﻿Spending cash or using credit on unnecessary inventory can hurt your liquidity. Improving your inventory management with an inventory analysis can also help reduce your current liabilities.
3. Decrease your current liabilities: If short-term obligations are overwhelming, you can renegotiate the terms. That means asking the creditor or lender to delay short-term payments.

Improving your business's quick ratio can make it easier to access funds and manage your financial obligations. But the quick ratio may not capture the profitability or efficiency of the company. Use it alongside other financial ratios and reports.

It’s easy to calculate the quick ratio formula and run financial reports with QuickBooks accounting software. Its cloud-based system tracks all your financial information and gives you fast access to your current assets and liabilities. You can spend less time running the numbers and more time driving success.

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