Quick Ratio Definition with Interpretation
Quick Ratio Definition – “A measure of company’s ability to meet its short-term obligations, also known as the acid test. To calculate the quick ratio, divide cash, receivables, and marketable securities by current liabilities”
This is a short – term solvency ratio which tells about the liquidity of the organisation. The other name of this ratio is acid-test ratio. It does not includes inventories, hence make it more appropriate ratio to measure the liquidity of the firm.
Formula of Quick Ratio
Quick Ratio = Quick Assets/ Current Liabilities
where Quick assets = Cash in hand + Cash at bank + Cash equivalents + Accounts receivables + Marketable securities
and Current Liabilities = Notes payable + Bills payable + Outstanding expenses + overdraft + creditors
Quick Ratio Example
To understand the quick ratio definition, let’s discuss an example. ABC Company has following types of liabilities and assets for the year ending 31 March 2017 given in rupees –
Plant and Machinery – 2,00,000
Land and building – 3,00,000
Goodwill – 50,000
Cash in hand – 50,000
Cash at bank – 1,00,000
Inventory – 1,20,000
Receivables – 25,000
Long term Liabilities
Loans from bank 3,00,00
Trade payables – 1,20,000
Overdraft – 30,000
The acid- test ratio = (50,000+1,00,000+25,000)/ (1,20,000+30,000)
= 1.1 : 1
Interpretation of Quick Ratio
The main objective of this ratio is to tell about the short term solvency of the organisation. In simple words, this ratio tells whether the firm has the ability to pay its short term debts. Analyst recommends that this ratio must be analyzed on a regular basis that is quarterly, half yearly and annually.
The ratio of 2:1 is the ideal ratio. Ratio equals to 1 means that the liabilities and assets are equal. So if firm has to pay its obligations, then it could suffer shortage of cash. A ratio below 1 is not at all good for the organisation. It means that the firm is going towards its insolvency. Too much higher quick ratio is also not good. This indicates that, the cash is kept idle and is not invested anywhere.
Importance of Quick Ratio
Without knowing its importance, quick ratio definition is incomplete. The most important role is to measure the ability of company to settles its short term debts. As current ratio is not the adequate measure of liquidity. Because it also includes inventory. However, quick ratio does not include inventory, hence is the correct measure of company’s short term financial health.