Quick Ratio

The quick ratio is a liquidity ratio that measures whether a company can pay its short-term obligations using only its most liquid assets. It divides quick assets, which are cash, short-term investments and receivables, by current liabilities. Because it leaves out inventory and prepaid expenses, it is a stricter test than the current ratio.

The ratio is also known as the acid-test ratio, a name borrowed from the old practice of testing metal with acid to see whether it was real gold. It is widely used by bank lenders, trade creditors, credit rating analysts and investors to judge whether a business could survive a sudden drop in sales or a squeeze on credit.

The standard calculation is:

• $\text{Cash}$ includes cash and cash equivalents such as Treasury bills with short maturities.
• $\text{Marketable securities}$ are short-term investments that can be sold quickly at a known price.
• $\text{Accounts receivable}$ are amounts owed by customers, net of the allowance for doubtful accounts.
• $\text{Current liabilities}$ are obligations due within one year, such as accounts payable, accrued expenses and the current portion of long-term debt.

An equivalent shortcut is current assets minus inventory and prepaid expenses, divided by current liabilities. Suppose a manufacturer has cash of $120,000, marketable securities of $30,000, net receivables of $210,000, inventory of $400,000 and prepaid expenses of $20,000. Its current liabilities are $450,000. Quick assets are $360,000, so the quick ratio is $360,000 divided by $450,000, or 0.80. The current ratio, which includes inventory and prepayments, is $780,000 divided by $450,000, or 1.73. The gap between the two shows that the company's ability to pay its bills depends heavily on selling stock.

A quick ratio of 1.0 or more is often treated as a comfortable level, because the company could pay all its current liabilities from quick assets alone. A ratio below 1.0 is not necessarily a problem, but it means the business relies on future sales or new borrowing to meet obligations. The right level depends on the industry and on the cash conversion cycle:

• Grocery chains and fast-food operators often run quick ratios well below 1.0 because they sell inventory for cash within days and pay suppliers later.
• Software and service companies usually show high ratios because they carry little inventory.
• Manufacturers with long production cycles tend to need higher ratios, because their stock takes months to become cash.

A very high quick ratio is not always good. It may mean the company is holding idle cash that could be invested, returned to shareholders or used to reduce debt. Analysts therefore compare the ratio with peers and with the company's own trend over several years.

The quick ratio assumes receivables will be collected on time, which may not be true if customers are in difficulty. Checking days sales outstanding alongside the ratio shows how fast receivables actually turn into cash. The ratio also ignores the timing of liabilities within the year, credit lines the company can draw on, and cash that is restricted or held abroad. It is a balance sheet snapshot, so it can be improved temporarily before a reporting date. For a fuller view, analysts combine it with working capital, operating cash flow and measures of solvency such as the debt-to-equity ratio over the longer term, rather than relying on any single measure of liquidity.