Quick Ratio Formula - How to calculate quick ratio, with example

Calculating Quick Ratio

One of the limitations of the current ratio is that it includes inventory and prepaid expenses in the numerator. However, these items are not as liquid as cash, marketable securities, notes receivable, or accounts receivable.

In the normal course of business, inventories must first be sold and the cash must be collected before it is available. Also most prepaid expenses such as prepaid insurance are to be consumed and cannot be readily converted into cash. A ratio used to supplement the current ratio that provides a more rigorous measure of liquidity is the quick ratio or acid test ratio, as it is sometimes called.

The quick ratio is computed by dividing the sum of the most liquid current assets –that normally includes cash, short-term marketable securities and net current receivables – by the current liabilities as follows

A ratio of 1.27 in both years shows that the firm is highly liquid. However, this observation is somewhat dependent on the collectability of the receivables included in the numerator.

Significance of Quick Ratio

The current ratio and quick ratio measures the adequacy of the firm’s current assets to satisfy its current obligations as of the balance sheet date. However, these ratios ignore how long it takes for the business to collect cash – an important aspect of liquidity of the firm. Since receivables and inventories normally make up large percentage of a company’s current assets, the quick ratio and current ratio may be misleading if there is an extended interval between purchasing inventory, selling it, and collecting cash from customers. Thus, the receivable turnover and inventory turnover ratios are two other liquidity measures that often yield additional information. These turnover ratios are sometimes called activity ratios.