Definition of Quick Ratio
- The quick ratio is a liquidity ratio that measures a firm’s ability to pay its short term liabilities with its most liquid assets.
- Unlike the current ratio, the quick ratio is only calculated using the most liquid assets.
- The ideal current ratio is 1:1.
- The higher the ratio, the safer is the firm as that would mean they have excess cash.
- However, if the ratio is too high, the firm has too much cash and should utilize it.
What is the Formula for the Quick Ratio?
- The quick ratio can be calculated in two methods.
- The first method is by adding Cash & equivalents, Marketable securities, Accounts receivable, and diving them by current liabilities.
Quick ratio = (Cash & equivalents + Marketable securities + Accounts receivable)/ Current liabilities
- The second method is by subtracting inventory and prepaid expenses from current assets and dividing them by current liabilities.
Quick ratio = (Current asset – Inventory – Prepaid expense )/ Current liabilities
The Quick Ratio in Practice
- Assume that bleu waters has:
- Current assets:
- Cash $ 30,000
- Account receivable $20,000
- Marketable security $20,000
- Prepaid expense $15,000
- Inventory $15,000
- Current liabilities:
- Account payable $50,000
- Term debt $30,000
- Bleu waters’ quick ratio is:
- ($ 30,000 + $20,000 + $20,000)/($50,000 + $30,000)= 0.875 OR
- ($100,000 – $15,000 – $15,000)/ ($50,000 + $30,000)= 0.875
- The ratio indicates that the firm does not have enough liquid assets (cash) to pay for the current liabilities.