How To Analyze a Company's Quick Ratio

Introduction

The Quick Ratio, also known as the Acid-Test Ratio, is an important financial metric for assessing a company’s short-term liquidity risk, or its ability to pay off its obligations over the next 12 months. Quick Ratio Analysis helps investors make well-informed decisions by comparing key financial ratios such as current liabilities to current assets. Specifically, the Quick Ratio is calculated by dividing the total of a company’s liquid assets (such as cash, savings accounts and marketable securities) by its current liabilities.

In this guide, we will explore the purpose and importance of Quick Ratios, what Quick Ratios should be used for, how to calculate a company’s quick ratio, and the benefits and drawbacks of the metric for investors.

Step 1: Identify Company Liabilities

The quick ratio (also known as the acid test ratio) is a common financial ratio used to measure a company's ability to meet their short-term financial obligations. To calculate the quick ratio, we must first identify a company's liabilities, both long and short-term, and compare those liabilities to the company's current assets.

Short-Term Liabilities

Short-term liabilities are costs that the company must pay within one year. These liabilities typically include accounts payable, accrued expenses, and loan payments. When calculating the quick ratio, companies must also factor in estimated tax payments, salary and bonus payments, and expected costs associated with customer refunds or product recalls.

Long-Term Liabilities

Long-term liabilities are costs that the company must pay over an extended period of time, typically over three years. Common long-term liabilities often include mortgages, corporate bonds, loans, and any other long-term debt payments. It should be noted that long-term liabilities should not be included in the quick ratio calculation as these costs are typically not paid within one year.

Current Assets

Current assets are liquid assets that can easily be converted into cash and are typically used to pay current or short-term liabilities. Current assets can include cash, marketable securities, accounts receivable, prepaid expenses, and inventory.

Step 2: Calculate the Quick Ratio

The quick ratio, also referred to as the acid test, measures a company’s ability to cover short-term liabilities with its most liquid assets. The quick ratio is generally considered to be a better indicator of a company’s liquidity since it excludes inventory and other current assets such as prepaid expenses.

The formula for the quick ratio is as follows:

• Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

Illustration of Quick Ratio Formula

Let’s take an example to understand how the quick ratio works. Let’s assume a company’s current assets are $500,000, and it has $400,000 in current liabilities. Cash and short-term marketable securities make up $200,000 and accounts receivable make up $300,000. The quick ratio of this company is calculated as follows:

• Quick Ratio = ($200,000 + $300,000) / $400,000 = 1.5

Unclear Figures in the Formula

For accurate calculation of the quick ratio, it is important to know the correct figures of the cash, marketable securities, and accounts receivable. These are all listed on a company’s balance sheet and must be taken into account when calculating the quick ratio.

Difference Between Current and Quick Ratios

The main difference between the current and quick ratio is the exclusion of inventory in the quick ratio calculation. The current ratio includes inventory but the quick ratio does not. This means that the quick ratio represents a much more accurate understanding of a company's liquidity as it does not rely on the sale of inventory for liquidity.

Interpretation of Quick Ratio Data

A company’s quick ratio is a valuable tool for analyzing the liquidity of the company’s current assets. This ratio measures the company’s ability to quickly turn current assets into cash. By understanding the quick ratio, analysts can identify what types of assets a company holds and how quickly these assets can be converted into cash.

Range of Positive Values

Quick ratios of 1 or higher indicate that the company has sufficient liquidity. This means that the company’s current assets are easily convertable to cash. On the other hand, a quick ratio of less than 1 indicates that the company does not have enough current assets to cover its liabilities.

Possible Messages of Negative Numbers

If a company’s quick ratio is negative, this could suggest that the company is highly leveraged. It also could mean that the company has difficulty generating sufficient current assets to cover its liabilities. Additionally, if the quick ratio is consistently negative, then the company may have difficulty meeting its short-term financial obligations.

Takeaways from Analysis

• A company's quick ratio is an important measure of liquidity.
• A quick ratio of 1 or higher indicates sufficient liquidity.
• A negative quick ratio can suggest that the company is highly leveraged and may have difficulty meeting its short-term financial obligations.

Understanding a Company's Quick Ratio

Analyzing a company's quick ratio is necessary in order to accurately assess its financial health. The quick ratio is a measure of a company’s ability to quickly and easily pay off its current liabilities. It is calculated by dividing current assets by current liabilities, and is expressed as a ratio. The higher the quick ratio, the better the financial standing of the company. In this article, we will explore factors that can affect a company's quick ratio results.

Differences in Accounting Practices

Because accounting standards can vary from country to country and company to company, results of a company’s quick ratio can vary depending on how it is accounting for its various assets and liabilities. For example, a company could account for its current liabilities differently than another company, which could lead to a variation in quick ratio results. It is important for investors to take such discrepancies into consideration when assessing a company’s financial health.

Financial Performance of the Company

The company’s financial performance can also have a major influence on its quick ratio results. If the company is experiencing stable or even increasing profits, then its quick ratio will be high. Conversely, if the company is experiencing losses, its quick ratio will be lower. It is important to examine a company’s recent financial results in order to accurately assess its quick ratio.

Seasonal Changes in Profitability

Those companies that are heavily dependent on seasonal business cycles can also have varying quick ratios. For example, a company that experiences a significant decrease in its profits during particular times of the year could have a lower quick ratio compared to the same company during peak times. It is important to take seasonal changes into account when calculating the quick ratio, as this can provide a more accurate picture of the company's financial health.

Examples of Quick Ratio Scores

Comparing a company’s quick ratio to industry averages gives investors a better way to determine if a company is in a stronger or weaker financial position. To help illustrate this concept, let's examine two companies—Apple Inc. and Amazon Inc.— and see how their quick ratio scores compare to what's considered a healthy score in their respective industries.

Industry Standards

The quick ratio, also known as the acid-test ratio, compares the company's liquid assets to its current liabilities. A quick ratio of 1 or higher indicates that the company is able to pay off all of its current liabilities without having to sell long-term investments. Industry standards vary across sectors, and a higher score is generally a more positive indicator of a company’s financial health.

Apple Inc.

Apple Inc. had a quick ratio of 1.39 for the trailing twelve months ending in September 2019. The tech industry has a median quick ratio of 1.17, so Apple's quick ratio is well above the industry average.

Amazon Inc.

Likewise, Amazon Inc. had a quick ratio of 1.68 for the twelve months ending September 2019. The retail industry average quick ratio is 1.26, which highlights Amazon's ability to pay off its current liabilities without having to sell its long-term investments.

Conclusion

The quick ratio is a useful tool that evaluates a company’s financial health and enables investors to assess whether a company has enough liquidity to overcome any potential financial hardships. It is a great way to evaluate the company’s overall financial success over time.

In this blog post, we provided a thorough overview of the quick ratio and its components, and discussed how to interpret the ratio and its limitations.

Summary of What Was Covered

We discussed how to calculate the quick ratio, different methods to interpret the ratio in comparison with peer companies, and how to analyze the results to inform future investment decisions. We also went into detail about the components of the quick ratio and how to analyze the ratio’s components as well.

Limitations of Quick Ratio Analysis

It is important to keep in mind that the quick ratio can be limited at times due to the exclusion of inventories and prepaids from the current assets category, which can potentially affect the accuracy of the results. Additionally, the quick ratio does not provide a comprehensive analysis of the company’s financial position; it is only one metric to consider when evaluating a company’s financial health.

Despite its limitations, the quick ratio remains an important tool for investors, as it provides a snapshot of the company’s financial health. Investors should consider the quick ratio in combination with other financial metrics to make well-informed investment decisions.