The quick ratio allows you to gauge whether a company can pay its bills in the short-term. In other words, if the company were up against the wall and had to pay their bills, can they do it immediately or would they have to rely on the liquidating longer-term assets?
There are two ways to calculate this ratio:
Quick Ratio: (Cash + Cash Equivalents + Accounts Receivables + Marketable Securities) / Current Liabilities
The second method is to simply take the Current Assets from the balance sheet and subtract Inventories. Then divide by Liabilities.
Scale of Importance: Medium
Alternative Name: Acid Test Ratio
Category: Liquidity Ratio
Discussion
This number indicates how quickly a company can pay its bills should it need to liquidate short-term assets. A result of 1 or greater shows that a company has the means to all its obligations.
You may be tempted to think that the higher the number for this ratio the better. It’s certainly better for the number to reflect that the company can pay its bills quickly. However, suppose you calculate the ratio to be 2 or 3. This means that the company can easily pay its bills and still have plenty left over. But, it also suggests the company has a lot of cash. Having too much cash means the company is not putting cash to use in the business. Successful companies optimize their cash to gain the highest returns for investors. Hoarding the cash will only increase it by the savings rate which is usually not enough to counter the effects of inflation.
It is quite possible that businesses will hoard cash in the short-term because they have a plan for its allocation. That’s why you shouldn’t consider this number in isolation as your basis for investing in the company. It can be used to investigate further. Read through the financial reports under the Management Analysis and Discussion section and look for any clues within the footnotes. Peruse stock forums such as StockTwits.com to see if you can gain insight as to why the company is hoarding cash. Take what is written in the forums with a grain of salt, though.
Businesswoman Reading Stock Listings in Newspaper
Your preference for (or against) owning a company in debt should also guide you when using this number. If you have high tolerance for debt and the company has a history of managing that debt responsibly, then a low Quick Ratio shouldn’t concern you as much. On the other hand, some people don’t like to invest in any company that carries a large debt. If you fall into the no-debt category, you can move on when low numbers are reported by they company.
One way you can feel more comfortable with this number is to see how they performed in previous periods. If the Quick Ratio was 0.5 before, how well did the company perform during time?
Also, keep in mind that balance sheets are a snapshot of a financial position at a specific point in time. The company may have had huge sales since they reported this number. That’s why you should always check the most recent quarterly reports and not focus solely on the yearly reports
Why No Inventories in the Calculation?
You may be wondering why inventories are removed from this calculation. In fact, the Current Ratio factors this in and constitutes the difference between the two ratios. Investors like to use the Quick Ratio as it inventories can be difficult to liquidate in a timely fashion, especially when a company is experiencing a bump in the road financially. They may not receive the full value of those inventories when they are forced to sell. The Current Ratio is available for investors who would like to see the impact of inventories.
What Should This Number Be?
In general, most analysts suggests having a quick ratio of at least 1. However, that is too simplistic a view and investors need to consider the industry the company is in. As mentioned, most ratios cannot stand on their own. Investors should consider several other factors, including how a company measures against the Quick Ratio (or Current Ratio) of the industry. If a company's number is on par with the industry, it simply means the company is keeping up in relation to its competitors. Note: matching the ratio against the industry does not necessarily mean the company is a good investment. It just means it's keeping up with the industry.
Is This an Important Ratio?
Some people put a lot of weight into the quick ratio or even the current ratio (which includes inventories). While it can be important to determine whether poorly run companies, it has less impact on well-run companies. It all has to do with the business cycle. If a company is capable of keeping more cash due to the efficiencies of its operations and its competitive advantage, the quick ratio won't matter as much. The business cycle will be enough to cover the costs. Also, well-run companies will weather any economic downturns more effectively than poorly-run companies.
Financial analysis is about constructing a story about the company. One ratio or measure cannot give a true picture of that story. Therefore, it's best to use this ratio in conjunction with several others. It is a useful indicator but you should never use it as the sole basis for an investment purposes. You'll miss out on good companies if you do.
Summary
The Quick Ratio gives you a good first look at a company of interest and how its managing its short-term liabilities. It is a great starting point in your analysis.
READY TO TEST YOUR QUICK RATIO KNOWLEDGE?
Everything you need to answer the questions is on this page. If you have read this page, you should ace the quiz. Good Luck!
I learned a lot from your article right from the start. I had never considered the optimization of money in the way that you describe it near the beginning of your post. It makes perfect sense to me now though. It’s best to be using your money in the most effective way possible and this doesn’t mean just letting it sit around. It’s not only a good thing to consider when looking into businesses to invest in, but also in your own personal life.
Hey Mariah, thanks for the comment. Exactly, businesses must learn to maximize their revenues. Why word harder than you should? When you have a quality management that knows this, they will earn more for their shareholders.
Best Regards,
Jim
Great post and good info.
In my opinion, I love the quick ratio, because you know the company has good papers, if they always have the long way, it would put some red flags to me.
I had bad experiences in the past, so for the, the short range is the best.
But again, this is my opinion.
Anyway, I think your post will help people to understand this matter.
Hey Emmanuel, thanks for your comment. It is a useful ratio, but like anything else, should not be used on its own. It’s just one piece of the puzzle for analysis. Best Regards, Jim
This was a great read! I didn’t do too well on the quiz, but this is new info for me so I had a hard time remembering some of the terminologies. However, one of my goals is to start investing more so I know I need to start learning and remembering this stuff more. Thank you for breaking it down in a way that was easy to understand.
Hey Holly, thanks for the comment. Feel free to take the quiz anytime you feel you need a refresher. I plan on publishing several quizzes on multiple topics to help people solidify the ideas. I am glad the post was useful to you.
Best Regards,
Jim
Wow, this is really useful because have learned something new Today! The quick ratio is a good tool for an investor and company owners. I really like the first method of calculating this ratio. However, the second method is not really clear to me and I will like more lights to be shed on it. Thanks to the admin for sharing this useful piece of information.
Thanks for the comment. Overall, most people can stick with the first method. The second method will likely lead to the same result as long as there aren’t other factors that make up the current assets, such as prepaid interest, deferred taxes, and other (or those items are small enough not to matter). When you use the first method you won’t have to deal with these issues and is obviously the preferred way.
Best Regards,
Jim
This is really informative. I never would have thought to pay attention to whether or not a company can pay its bills when hard times hit when looking at investing. One thing that I’ve read that is good business practice is to keep 6 months worth of wages for employees in case of bad times. So that’s one possibility that a business might be hoarding cash.
Hey Nicole, thanks for the comment. Yes, the ability for a company to pay its bills is something that many don’t consider but should. It’s one of those subtleties of financial analysis. Learning about those subtleties can save a lot of grief to an investor’s portfolio.
Best Regards,
Jim
Thanks for a very informative post. I have run my own businesses for the past 20 years but have never come across the quick ratio. This would be great if you were buying a new business to do some due diligence, or to keep track of your own business and how its doing, I come across so many people who have no clue how their business is doing. A great find thanks.
Hey Martin, thanks for the comment. You bring up some good points about keeping track of your business over time. Since investors become business owners to a degree when they buy shares of a company, it holds for them too. I wrote about this in another post –> https://financialmarketseducation.com/buying-a-stock-means-owning-a-company