6 Myths Uncovered About Quick Ratios

Quick Ratio

The quick ratio - aka the quick assets ratio or the acid-test ratio - is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.

As of March 31, 2010, with amounts expressed in Rs. crores, XYZ’S quick assets amounted to 13,041 (balance sheet); while current liabilities amounted to 4,030 (balance sheet). By dividing, the equation gives us a quick ratio of 3.24. XYZ being in the services sector does not have any inventory on its balance sheet and this quick ratio and current ratio come out to be the same.

Some presentations of the quick ratio calculate quick assets (the formula’s numerator) by simply subtracting the inventory figure from the total current assets figure. The assumption is that by excluding relatively less-liquid (harder to turn into cash) inventory, the remaining current assets are all of the more-liquid variety. Generally, this is close to the truth, but not always. In some companies, restricted cash, prepaid expenses and deferred income taxes do not pass the test of truly liquid assets.

Thus, using the shortcut approach artificially overstates more liquid assets and inflates its quick ratio.

The quick ratio is a more conservative measure of liquidity than the current ratio as it removes inventory from the current assets used in the ratio’s formula. By excluding inventory, the quick ratio focuses on the more-liquid assets of a company.

The basics and use of this ratio are similar to the current ratio in that it gives users an idea of the ability of a company to meet its short-term liabilities with its short-term assets. Another beneficial use is to compare the quick ratio with the current ratio. If the current ratio is significantly higher, it is a clear indication that the company’s current assets are dependent on inventory.

While considered more stringent than the current ratio, the quick ratio, because of its accounts receivable component, suffers from the same deficiencies as the current ratio - albeit somewhat less.

Both the quick and the current ratios assume a liquidation of accounts receivable and inventory as the basis for measuring liquidity. While theoretically feasible, as a going concern a company must focus on the time it takes to convert its working capital assets to cash - that is the true measure of liquidity.

Thus, if accounts receivable, as a component of the quick ratio, have, let’s say, a conversion time of several months rather than several days, the “quickness” attribute of this ratio is questionable.

Investors need to be aware that the conventional wisdom regarding both the current and quick ratios as indicators of a company’s liquidity can be misleading.

Get free share market live tips here.