Quick Ratio - or acid test ratio - is used to evaluate company’s ability to overcome its short-term liabilities with its most liquid assets, like cash and cash equivalents, marketable securities and accounts receivable. It can be calculated by deducting inventories from the total short term assets, and dividing them by current liabilities.
Quick ratio is more conservative than its father - current ratio, because when calculating it, we should deduct inventories, which are not always so liquid. Inventory is excluded because some companies have difficulty turning their inventory into cash. It is because some companies are overestimating their ability to cash out their inventory, when thinking, that they are producing the best production that is on demand whenever they want to sell it. In real life it is different and usually it takes some time to realize inventory from the stock.
Quick ratio shows company's short-term financial strength. The higher quick ratio, the better position of the company is. Depending on the type of company, quick ratio can be lower or higher. In general, the ratio of 1 or higher is more accepted, but usually it is lower if the company is merchant or in other words commercial - buying goods from suppliers and reselling them to its customers. It means, that the company is not creating any added value to the product, but just acts as a merchant, who finds some cheaper goods in China, imports them to some country in Europe, adds his mark-up and sells to us - those, who will not go for one item purchase to China. If the quick ratio is more than one, it shows that the company is manufacturing company. Because short term assets consist of the unfinished contracts, it means that manufacturing company may have quite numerous assets in those unfinished contracts and accounts receivable, so their short term assets may be higher than short term liabilities.
Creditors like this quick ratio, because it reveals a company’s ability to liquidate its liabilities under the worst possible conditions in the short term. The creditors should know, that the company which has lower credit rating, has a lower possibility to borrow in the market, so it should have enough liquid asset, like cash and its equivalents to show good quick ratio. If the ratio is too low, the creditors should check how the company is paying its obligations to the suppliers and what the current debt in the company is. It is possible, that the company was facing liquidity problems and took an overdraft or short term loan to get money. If the ratio is low, creditors should check what the inventories in the company are. It might be that the current ratio is so low, because company relies on inventory too much and overestimates their abilities, or maybe their inventory turnover is too low, which means that the company is holding high sums of assets in inventories, which are stocked. We shouldn’t forget that the company is facing stocking costs as well, so if the company will have too much inventory with a very low turnover, it can indicate low effectiveness of the company and a higher profitability if this point would be fixed.
Even if the inventory is kept as illiquid, when calculating quick ratio, it is possible that accounts receivable might be too high and at the same time showing good quick ratio, but at a hard times accounts receivable might be more illiquid than deducted inventories. It means that the customer debt at a current time cannot be taken back so quickly, but the inventory might be cashed out quicker than it. When evaluating and comparing company’s liquidity more strictly it is useful to calculate cash ratio, which shows how much of company’s obligations it can pay with the cash held in hand.
To sum up, we can say that quick ratio definition is good, because it deducts inventories, which is usually illiquid at hard times in short term and may indicate a problem of possible low inventories turnover in the company.
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