The quick ratio is a variation of the current ratio. However, a quick ratio is considered by many to be a more conservative estimate than the current ratio. This characteristic fetches it the nickname of being the “Acid test ratio”.
The difference between the current ratio and the quick ratio is the fact that quick ratio excludes the inventory. In theory this may seem like a small difference, however in practice anyone who is aware about the difficulties involved in liquidating inventories at the right price will vouch for the conservativeness of this ratio. The quick ratio has been discussed in greater detail in this article.
Formula
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
Meaning
The quick ratio checks the company’s performance to fulfill its obligations in a situation when it is not able to liquidate its inventory. In such a situation the company will have to pay its current liabilities out of the cash and cash equivalents that it has on hand and the amount of money it has already tied up in accounts receivables. The ideal quick ratio is considered to be 1:1. However, this varies widely according to the different credit cycles prevalent if different industries. Hence an analyst must look at competing firms and the industry average before forming opinions based on the current ratio.
Assumptions
There are no assumptions made regarding the inventory, because it is excluded from the calculation of this ratio. However, there are assumptions made about debtors and the fact that they will pay up on time to finance the payment of short term liabilities that a company has on hand.
Wrong Interpretations
- The quick ratio of the company can become unreasonably higher because of a large amount of accounts receivables that the company may have on hand. The true measure of the liquidity management of a company is its ability to complete the cash to cash cycle in the fastest possible time. However if the company has a track record of being able to recover its dues on time large receivable may be overlooked.
- Since the quick ratio is a variation of the current ratio it suffers from all the shortcomings faced by the current ratio.
