Why Learn the Quick Ratio

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.

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.