What is The Quick Ratio and Why is it Important?
Recently, Tom provided insight to Insider Magazine regarding The Quick Ratio which we wanted to share with our network as well. Tom has 15 years of corporate finance experience and advises several small businesses on how to maximize profits and cash flow. If you or someone you know owns a small business and could use Tom’s help, give him a call at 706-864-4281.
What is “The Quick Ratio” and Why is it Important?
The quick ratio (QR) indicates a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets. In other words, The quick ratio measures a company’s capacity to pay its current liabilities without needing to sell its inventory or obtain additional financing. The higher the ratio, the better a company’s liquidity and financial health; the lower the ratio, the more likely the company will struggle to pay its debts. (Investopedia.com)
Knowing the Quick Ratio for a company is relatively useless without a reasonable understanding of the company’s business model. You need to know some details about the components of the QR, namely cash, accounts payable, and accounts receivable. Failure to understand these components could lead you to a very misleading conclusion, both positively or negatively. For example, the QR of a shipbuilding company that builds 2-3 cruise ships per year will be quite different from a retail outlet that takes in and disburses money daily. The latter would likely have a lower QR but that doesn’t necessarily make it a weaker company
What is considered a good quick ratio?
The obvious answer is greater than one, meaning the company has enough cash on hand to pay its current liabilities. But if the company collected money from its customers every 15 days but only had to pay its suppliers every 30 days, then the company’s accounts receivable would be about half of the accounts payable, resulting in a QR below one. Someone analyzing this company may see this as a negative, when in effect the company is minimizing the use of cash for working capital, freeing up that cash for other purposes, which would be hugely positive.
What is the difference between the Quick Ratio and the Current Ratio?
The QR’s big brother, the Current Ratio, includes inventory in the numerator. Inventory is the third major component of working capital (alongside accounts receivable and accounts payable), but since it can’t be immediately converted to cash it is excluded from the QR. If a company can turn its inventory relatively quickly, say faster than its accounts payable are due, the CR is probably a better measure of liquidity than the QR. If inventory turns over slowly, say less than monthly, the QR will give an investor a better sense of the company’s liquidity. Using the example above, the retailer can quickly put inventory on sale to accelerate sales and cash flow, whereas the shipbuilder from our example above doesn’t have such an option to accelerate cash in the short term.
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