The quick ratio is used to evaluate whether a business has enough liquid assets that can be converted into cash to pay its bills. The key elements of current assets that are included in the ratio are cash, marketable securities, and accounts receivable. Inventory is not included in the ratio, since it can be quite difficult to sell off in the short term, and possibly at a loss. Because of the exclusion of inventory from the formula, the quick ratio is a better indicator than the current ratio of the ability of a company to pay its immediate obligations.
To calculate the quick ratio, summarize cash, marketable securities and trade receivables, and divide by current liabilities. Do not include in the numerator any excessively old receivables that are not likely to be paid, such as anything over 90 days old. The formula is:
(Cash + Marketable securities + Accounts receivable) ÷ Current liabilities = Quick ratio
Despite the absence of inventory from the calculation, the quick ratio may still not yield a good view of immediate liquidity, if current liabilities are payable right now, while receipts from receivables are not expected for several more weeks. This can be a particular concern when a business has granted its customers long payment terms.
The ratio is most useful in manufacturing, retail, and distribution environments where inventory can comprise a large part of current assets. It is particularly useful from the perspective of a potential creditor or lender that wants to see if a credit applicant will be able to pay in a timely manner, if at all.
For example, Rapunzel Hair Products appears to have a respectable current ratio of 4:1. The breakdown of the components of that ratio are:
The component breakdown reveals that nearly all of Rapunzel's current assets are in the inventory area, where short-term liquidity is questionable. This issue is only visible when the quick ratio is substituted for the current ratio.
The quick ratio is also known as the acid ratio, the acid test ratio, the liquid ratio, and the liquidity ratio.