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Quick ratio

Method of calculation

Formula for quick ratio (acid test): (current assets - inventory - short-term prepayments) / short-term liabilities

Ratio's description

This ratio indicates to what extent the company can cover current liabilities with current assets, which may be converted into cash in short time required for their encashment (so called liquid assets). The value of liquid assets is obtained by decreasing the value of current assets by two least liquid elements: inventory and short-term prepayments. Because of this, the values of quick ratio will always be lower that the values of current ratio. The greater the difference between them, the more important for the maintanance of financial liquidity the level of inventory (and possibly short-term prepayments) is. Thus, the ratio allows to determine the company's ability of quick coverage of current liabilities. The reference value of this ratio should hover around 1.

Ratio's interpretation

  • Ratio's values below 0.5 should be interpreted as the loss of financial liquidity, while the values above 1.5 as excess liquidity.
  • When assessing the changes in ratio's value over time (over few periods):
    • the decrease of ratio's value is interpreted as a deterioration of financial liquidity and the deterioration of the ability of quick coverage of current liabilities (the decrease is interpreted respectively as an improvement),
    • maintaining the ratio's value close to 0.5 or lower is interpreted as an increased risk of financial liquidity loss,
    • the increase of ratio's value should be interpreted with additional care if it is accompanied by the elongation of the receivables cycle (eanaliza.pl system allows to calculate this ratio). The increase of ratio's value with simultaneous increase of receivables turnover ratio may indicate problems with receivables collecting, which deteriorates the liquidity. In this case the analysis should be complemented with the assessment of cash ratio.

       

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