Quick ratio analysis is used to examine the ability of a business to pay its bills. In essence, any quick ratio of 2:1 or better shows that a company has an excellent ability to pay its short-term obligations.
The quick ratio is based on those assets and liabilities on a company's balance sheet that are most liquid, which usually results in the following formula:
(Cash + Marketable securities + Accounts receivable) ÷ Accounts payable
The exact contents of the ratio can vary, depending on the types of assets and liabilities that a company holds. The main point of constructing the ratio in this manner is to avoid the more illiquid assets, which means inventory and fixed assets. By doing so, we arrive at a ratio of essentially the cash that should be available in the short term to the cash requirements of the business in the short term.
The ratio can also be misleading. Consider the following issues:
- Window dressing. If a company knows that its quick ratio is being reviewed by a creditor or lender, it can take certain steps to make the ratio look better than it really is, by delaying the timing of payments and the recognition of supplier invoices. You can sidestep this problem by requesting sufficient information to calculate the ratio for many periods in the past, when the company was presumably not engaged in altering its reported results. Viewing the ratio on a trend line will make it more apparent that window dressing is being used in the current period.
- Forward looking. The quick ratio, like most ratios, is based on historical information, and so gives no guidance into the future prospects of a business. You can sidestep this issue to some extent by also tracking the company's trend line of customer orders, which is intended to provide guidance about future results.
- Payment exclusions. The quick ratio does not consider other types of liabilities that may require payment in the short term, such as a lawsuit settlement, a dividend payment, or the purchase of an expensive fixed asset. These payments can drain a company's cash account, so that the next quick ratio has a decidedly worse outcome than the ratio calculated for the preceding reporting period. Some of these payouts are indeed unexpected, but others (such as dividend payments) can be anticipated by reviewing the company's history of such payments.