## Quick Ratio

Quick Ratio:

In this article, you will discover what the Quick Ratio is, why the Quick Ratio is important, the purpose of the quick ratio, the meaning of the Quick Ratio, examples of Quick Ratio, and sample quick ratios.

The Quick Ratio, also referred to the acid test ratio, is an important ratio which helps business owners, entrepreneurs, managers, and investors determine the company’s ability to pay its short term debt without relying on the sale of inventory.

The quick ratio, which is in the category of liquidity ratios, can be compared from year to year to determine whether the company’s liquidity is improving, declining or remaining relatively stable. The process of comparing the quick ratio of one year to another year is called trend analysis. Trend analysis is important since it shows whether the company’s performance is improving. A company’s quick ratio can also be compared to the industry’s quick ratio to determine how well the company is doing relative to the industry as a whole.

The purpose of the Quick Ratio is to determine how well a company can pay its short term debt without relying on the ending inventory levels. Bankers like using this ratio since it tells them this… If a company was to go out of business today, will it have enough cash and other assets (except for inventory) to pay its short term debts. Bankers and other investors understand when a company goes out of business, the inventory is usually worthless and purchased for pennies on the dollar. As a result, the quick ratio removes the ending inventories from the equation.

The three accounts needed in order to determine the quick ratio are total current assets, total ending inventory (finished inventory) and total current liabilities. Other inventory accounts are required for companies such as manufacturing firms who deal with raw materials or unfinished inventories. Furthermore, a manufacturer/processor would require the raw materials account as well as work in progress account when calculating the Quick Ratio.

Quick Ratio Formula:
The quick ratio is achieved by subtracting inventories (both finished and unfinished inventories) from total current assets. Now, take the resulting figure and divide current liabilities. Below shows the Quick Ratio Formula.

Quick Ratio = (Current Assets – Inventories) divide the Current Liabilities.

The accounts required to calculate the Quick Ratio are found on the Balance Sheet and not the Income Statement. Recall from previous discussions, the Income Statement consists of revenues, Cost of Goods Sold and Operating Expenses. The Balance Sheet, on the other hand, consists of Assets, Liabilities and Equity.

Let’s look at a number of scenarios so that you fully understand the Quick Ratio and the quick ratio formula.

Quick Ratio of a Retailer:
Assume you own a retail store in Orange County, California. Further assume the product line you carry consists solely of clothing for men, women and children. You have been business for two years.

The following balance sheet data, required to calculate the quick ratio, was sent to you by your accountant. Moreover, this data represents the required balance sheet accounts and account values at the end of year two.

 ASSETS: LIABILITIES: Current Assets: Current Liabilities: Cash \$ 50,000 Accounts Payable \$ 5,000 Marketable securities \$ 1,000 Short-term Bank Loan \$25,000 Accounts Receivable (Net) \$ 14,000 Total Current Liabilities \$30,000 Ending Inventory of Clothing \$ 100,000 Total Current Assets \$165,000

Using the above balance sheet items, lets calculate the clothing store’s quick ratio for the year ending December 31, 201B. Recall, the formula needed to calculate the quick ratio is as follows:

 Quick Ratio = Current Assets - InventoriesCurrent Liabilities

Now we must input the data from the balance sheet in order to calculate the quick ratio for the clothing store. Below calculates the quick ratio for the clothing company as at December 31, 201B to be 2.17.

 Quick Ratio = Current Assets - InventoriesCurrent Liabilities = \$165,000 - \$100,000\$30,000 = 2.17

What does a quick ratio of 2.17 mean? Here a simple explanation. Without considering the inventory accounts, the clothing store has 2.17 times more current assets than current liabilities (IE slightly more than twice as many current assets than current liabilities, without considering the value appearing in the inventory account).

Let’s define the 2.17 in terms of a dollar value which most individuals can better comprehend. So for every \$1.00 owed by the company in short-term debt (current liabilities), the clothing companies has \$2.17 of current assets (excluding inventory). In theory, if the clothing company closed its doors on December 31, 201B and thus, did not sell any more products, then it would have the ability to pay all of its short-term debt using all current assets except for its clothing inventory.

The higher the quick ratio, the stronger the company is perceived to be. Moreover, a higher quick ratio means a business does not have to rely as much on selling its inventory relative to similar operations with a lower quick ratio.

Quick Ratio and Trend Analysis:
Now let’s assume you want to compare the quick ratio in the second year of operation with the quick ratio of the first year. That said, you contact your accountant and ask for your company’s current assets and current liabilities account balances for both year one and year two. Your accountant provides you with the following information.

 Year 1 Year 2 Current Assets: Cash \$ 34,000 \$ 50,000 Marketable Securities 0.00 1,000 Accounts Receivable 15,000 14,000 Inventory of Clothing 120,000 100,000 Prepaid Insurance 1,000 0.00 Total Current Assets \$175,000 \$165,000 Current Liabilities: Accounts Payable \$ 4,000 \$ 5,000 Taxes Payable 6,000 0.00 Short term Bank Loan 45,000 25,000 Total Current Liabilities \$55,000 \$30,000

Now let’s use the quick ratio formula to calculate the clothing company’s quick ratio for each year ending December 31, 201A and December 31, 201B.

The Quick Ratio for Year 1 (201A) is calculated as follows:

 Quick Ratio = Current Assets - InventoriesCurrent Liabilities = \$175,000 - \$120,000\$55,000 = 1.00

As you can see, the quick ratio in year one is 1.00. What does a quick ratio of 1.00 mean? Without considering the clothing inventory, the company has 1.00 times more current assets than current liabilities. In order words, the company has the same value of current assets as it has of current liabilities; without considering the ending inventory of clothing. Furthermore, if the company closed its doors on December 31, 200A, they would have just enough current assets to pay their current or short term suppliers; without relying on selling any more of its clothing inventory.

As discussed earlier, we calculated the quick ratio of the clothing company in year two at 2.17. Recall, here is how we calculated the quick ratio in year two.

 Quick Ratio = Current Assets - InventoriesCurrent Liabilities = \$165,000 - \$100,000\$30,000 = 2.17

Again, the meaning of a 2.17 quick ratio is as follows. Without considering the ending inventory of clothing, as at December 31, 201B, the business has 2.17 times more current assets than current liabilities. In other words, the company has more than twice as many current assets than it has current liabilities; without considering the value appearing in the ending clothing inventory account).

Quick Ratio and Trend Analysis Summary:
So what is the importance of knowing the quick ratio in year one is 1.00 and the quick ratio in year two is 2.17. Again, comparing ratios including the quick ratio from one year to another fiscal period is referred to as ratio trend analysis. Through trend analysis, you can determine whether your business is improving, declining or remaining stable.

Since the quick ratio is increasing from 1.00 in year one to 2.17 in year two, we can conclude the clothing company is trending upwards and therefore is improving its performance as it relates to paying its short term debts without relying on its inventory. Furthermore, the quick ratio indicates the clothing company’s ability to pay its short term debt, without relying on inventory, has more than doubled in the second year of operations.

Quick Ratio for a Manufacturer or Processor:
The quick ratio formula for a manufacturing or processing company is the same as a retailer or service provider. The number of inventory accounts used in the formula, however, is the only difference. Furthermore, a manufacturer and related entities who convert raw materials into finished goods may have hundreds of types of inventory accounts; such as, finished goods product A, finished goods product B unfinished goods (as referred to as work in progress) and finally raw materials.

When calculating the quick ratio for any business, for that matter, all ending inventories are subtracted from the current assets. Moreover, it doesn’t matter the stage in which the ending inventory currently stands. Again, finished product (goods), semi finished product, and raw materials are all subtracted from the current assets when calculating the quick ratio.

Let’s look at an example of the quick ratio for a manufacturer or processor. Assume the following balance sheet accounts necessary for calculating the quick ratio for a manufacturer or processor.

 ASSETS: LIABILITIES: Current Assets: Current Liabilities: Cash \$ 20,000 Accounts Payable \$ 10,000 Accounts Receivable \$ 30,000 Short-term Bank Loan \$ 40,000 Finished Ending Inventory \$ 75,000 Total Current Liabilities \$50,000 Unfinished Ending Inventory \$ 15,000 Raw Materials \$ 10,000 Prepaid Insurance \$ 10,000 Total Current Assets \$ 160,000

Ok, we have enough information to calculate the quick ratio for a manufacturer or processor if raw materials into finished goods.

As a refresher, below shows the Quick Ratio Formula.

 Quick Ratio = Current Assets - InventoriesCurrent Liabilities

Using the above example, we can calculate the quick ratio as follows.

 Quick Ratio = Current Assets - InventoriesCurrent Liabilities = \$160,000 - \$100,000\$50,000 = 1.20

As you can see, the inventories amount to \$100,000 and consist of the ending inventory of finished goods, the ending inventory of unfinished goods as well as raw materials. Again, ALL inventory items are subtracted from the total current assets when calculating the quick ratio.

Let’s complete this quick ratio example by explaining what the above quick ratio of 1.20 means. A quick ratio of 1.20 means the company has 1.2 times more current assets than current liabilities (without considering the sale of any ending finished goods, unfinished goods, or raw materials). Said another way, a quick ratio of 1.20 means the company has the ability to use its current assets to fully repay its short term debt (without relying on its ending inventory of finished goods or ending inventory of unfinished product).

Quick Ratio for a Service Business:
Now let’s look at the quick ratio for a service business. A service business calculates the quick ratio in the same way as a retailer, manufacturer or processor. If you are a service type business that doesn’t sell any product, you will not have any inventories. As a result, your current ratio will be the same as your quick ratio. Please refer to our discussion on liquidity ratios for a complete explanation.

If you are a service business who carry inventory, then you will need to consider your ending inventory, on the balance sheet, when calculating the quick ratio. An example of a service business that has an ending inventory would be a Plumbing & Heating service that purchases furnaces from a supplier and subsequently resells them to their customers or end consumers.

This concludes our discussion on quick ratio, the quick ratio formula and the meaning of the quick ratio. For complete information on Ratios and Ratio Analysis, please refer our in-depth discussion contained within the following related ratio articles and sub-articles.

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