Quick Ratio | Acid Test | Formula | Example | Calculation

Quick Ratio

Quick Ratio or acid test ratio is the liquidity ratio is used to measure the company’s ability to pay its current liabilities with its only quick assets when they come due. Quick assets are called the current assets which must be converted within 90 days or short term. Quick assets may be the cash, cash equivalent, current account receivable, short term investment or marketable securities.

Short term investment or marketable securities are the quick assets because it can be converted in the cash within 90 next days. On the Newyork stock exchange any stock considered as the marketable security on any investor it can easily be sold by the company after the market open.

The quick ratio is called the acid test ratio because this ratio is used to test metal for gold by early minors. If the metal passed the acid test when it considered the precious metal. But if the acid test failed then the metal corrodes from acid and have no value.

The acid test of finance shows the efficiency of the company to convert its assets in cash to pay the current liabilities of the company.

Formula

Quick ratio formula can be calculated by the sum of cash, cash equivalent, short term investment, and current receivable and divide it by the current liabilities.

Quick Ratio = (Cash + Cash equivalent + Short term investment + Current receivable)/Current liabilities

On the financial statement of the company if the breakdown of assets not given then you can calculate this in a second way. You just need to subtract the inventory, and prepaid expenses from total current assets and divided by the total liabilities to calculate the quick ratio.

Quick Ratio = (Total current asset – Inventory – Prepaid expenses)/Current liabilities

Analysis and Interpretation

QR is used to measure the efficiency of the company to pay its current liabilities fro its quick assets. If the company has the greater number of quick assets then it can easily meet its current obligations without seeling of the long term assets or capital assets of the company.

The companies which sell its long term asset or capital assets to pay current obligations will have the bad performance because of which investors know the bed performance of operations of such type of companies. So these companies have a low quick ratio.

For a company, high quick ratio is better because it is a good sign for the company. Company with high QR is better and have more quick assets as compare to the current liabilities of the companies. If the company has QR 1 it means that quick assets and current liabilities of the company are equal. With 2 QR company has double quick assets as compared to the current liabilities of the company.

Example

John has the clothing store. He applies for the loan to remodel the front of the store. For compute the quick ratio bank take the detailed balance sheet of John. On the balance sheet, he has the accounts listed below

  • Cash = 10,000 dollars
  • Account receivable = 5,000 dollars
  • Stock investment = 1,000 dollars
  • Inventory = 5,000 dollars
  • Prepaid taxes = 500 dollars
  • Current liabilities = 15,000 dollars

The quick ratio of John calculated by the bank as

1.07 = (10,000 + 5,000 + 1,000)/15,000

As the Quick ratio is greater then 1 it means that John can pay its current liabilities with its quick assets. After payment of liabilities, John still has left the quick assets.

If John did not provide the detailed balance sheet to the bank then John has the following account in its balance sheet.

  • Inventory = 5,000 dollars
  • Prepaid taxes = 500 dollars
  • Total current assets = 21,500 dollars
  • Current liabilities = 15,000 dollars

Bank use the second method to calculate the quick ratio as

Quick ratio

Quick ratio = (21,500 – 5,000 -500)/15,000

QR= 1.07

 

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