Quick Ratio Or Acid Test Ratio –
Quick Ratio is a liquidity ratio that shows company’s ability to pay off its short term liabilities or debt by having assets that are easily convertible into cash. The term Acid test suggest quick test action. Quick actions means quick conversion of assets into cash.
Quick Ratio is more conservative than current ratio. This ratio means whatever assets which are easily convertible in cash quickly are used as a numerator in this formula like cash and equivalents, marketable securities and account receivable.
Quick Ratio = (Cash & Equivalents + Marketable Securities + Accounts Receivables) / Current Liabilities
Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
The reason we use cash & equivalents, marketable securities and account receivables are because securities are liquid assets and receivables are assets which receives in specific time period.
Also the reason why we don’t add inventory and prepaid expenses are because inventory takes longer time to convert into cash and prepaid expenses are cannot be used to pay other liabilities.
There is no change in current liabilities terms and constituents.
Quick Ratio of company A = 140 / 90 = 1.56
Quick Ratio of company B = 110 / 110 = 1
Quick Ratio of company C = 70 / 100 = 0.7
The ratio of company A is higher than 1 that is 1.56 which is highly good, it shows that it can instantly get rid of its short term liabilities or current liabilities.
The ratio of company B is equal to 1 which is normal ratio which means company has enough quick assets which can be instantly liquidated to pay off its short term liabilities or current liabilities.
The ratio of company C is less than 1 that is 0.7 which signals the bad sign, ratio below 1 means company has not enough quick assets to pay off its short term liabilities or current liabilities.
This ratio is really important because sometimes current liabilities have to pay at specific time, to pay that liabilities quick assets can be helpful. Inventory takes longer time to convert into cash or sometimes inventory don’t get good market price so there we can face loss.