Quick Ratio is a more conservative measure of a firm’s short-term liquidity than Current Ratio. It is especially useful for analysing manufacturing firms and retailers.
The Quick Ratio is a more conservative test of a company’s liquidity, than the Current Ratio We have learnt that a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble. Unfortunately, some current assets – such as inventories – may be worth less than their value on the balance sheet. (Imagine trying to sell old PCs or last year’s fashions to generate cash – you would be unlikely to receive anything close to what you paid for them.) Current assets less inventories, divided by liabilities equals Quick Ratio.
Quick Ratio formula
Quick Ratio = (Current assets – Inventories)/Liabilities
In the event that short-term obligations need to be paid off immediately, there are situations in which the current ratio would overestimate a company’s short-term financial strength. By taking inventories out of the equation, Quick Ratio lets us find out if a company has sufficient liquid assets to meet its short-term operating needs. It is especially useful for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories.
Calculating Quick Ratio
Quick Ratio is simply calculated by subtracting Inventories from Current Assets and dividing the result by Current Liabilities. Inventories, Current Assets and Current Laibilities can be found in the Balance Sheet filed in the firm’s Annual Reports. Annual Reports can usually be found at the firm’s website or from SEBI EDIFAR database. Current Assets are those likely to be used up or converted into cash within one business cycle, usually defined as one year. Liabilities, similarly are those that have to be paid within a period of one year. There are several types of inventories, including raw materials that have not yet been made into a finished product, partially finished products, spare parts and finished products that have not yet been sold.
Rough benchmarks for analysing a stock’s Quick Ratio
In general, a quick ratio higher than 1.0 puts a company in fine shape, but always look to other firms in the same industry to be sure.
You may also like to learn more on other financial strength measures, as below.