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Quick ratio

The quick ratio shows the ability of a company to meet short term liabilities. It is calculated by subtracting a company's inventories from its current assets and then dividing this figure by its current liabilities:

Quick ratio = (Current assets - Company's inventories)/liabilities

Because the calculation does not include as an asset any inventory the company has, this ratio is considered a more stringent measure of financial strength than the current ratio, earning it the nickname the "acid test".

Inventory is not included because in most business sectors it would be difficult to convert inventory into cash at short notice.

What is the difference between the current and quick ratio? The quick ratio is similar to the current ratio but does not include inventory as a company asset. This makes it a much more stringent "acid test" of the company’s strength in a worst-case scenario.

 

The quick ratio therefore measures how a company would fare under the worst-case scenario – if it were called upon to pay back all its liabilities immediately.

Shareholders generally look for a quick ratio of at least 1:1, although again this will differ depending on a company's industry.

The quick ratio becomes more important to shareholders in times of economic downturn, because this raises the likelihood of any such worst-case scenario occurring.

Be particularly alert to any changes in a company's quick ratio as a rapid decline should ring alarm bells to investors.

Look for a quick ratio of at least 1:1, although this will differ depending on a company's industry.

 

Summary

So far you have learned that...

  • ... calculating the quick ratio shows the ability of a company to meet short term liabilities.
  • … the quick ratio is an "acid test" of the company's ability to meet its short-term liabilities and is considered more stringent than the current ratio.
  • ... the quick ratio therefore measures how a company would fare under the worst-case scenario – if it were called upon to pay back all its liabilities immediately.
  • ... shareholders generally look for a quick ratio of at least 1:1, although again this will differ depending on a company's industry.