In financial accounting, companies can use a quick ratio, or acid-test, to determine short-term liquidity. To calculate this ratio, the company’s current assets value, excluding inventory, is divided by the company’s current liabilities. The goal of an acid-test is to estimate the company’s financial strength or weakness. This is measured by the company’s ability to pay off outstanding debts immediately using liquid assets.
The assets used to calculate the quick ratio include cash and items that can be quickly converted into cash, at — or close to — their book values. These assets include marketable securities and accounts receivables. Generally, real estate holdings are excluded from the assets, since these holdings may not be sold quickly.
Inventory is also excluded from the quick ratio formula, since it may not be sold off immediately to generate cash flow. Inventory may also be sold for less than its book value. Items sold to quickly generate revenue are often sold at prices less than the full retail value.
Creditors sometimes use quick ratios. The lender may decide to extend credit, or not, based on this ratio. Generally, a ratio of 1 is considered acceptable. This indicates that the company has immediate access to $1.00 US Dollar (USD) for every $1.00 USD of debt the company is carrying. A quick ratio below 1 can indicate that the company cannot immediately pay off its debts with its current cash position.
Investors also use the quick ratio to help determine the company’s stock value. Generally, a ratio of 1 or higher is desirable. Conversely, if the ratio is very high, such as 10, this could be undesirable. A very high ratio may indicate that the company is hoarding cash instead of investing it back into the company to generate growth. This could encourage the potential stock buyer to investigate the company further.
Acceptable quick ratios can vary by industry. Investors and creditors can compare a company’s quick ratio to its competitors’ ratios. If a ratio is high or low — but consistent with ratios throughout the industry — it will most likely be considered acceptable by investors and creditors.
Another measurement used in financial accounting, the current ratio, includes all of the company’s current assets. These assets are divided by the current liabilities. Investors and creditors can compare the quick ratio to the current ratio. If the current ratio is significantly higher than the quick ratio, this may indicate that the company is dependent on selling its inventory, or borrowing funds, to meet its financial obligations.
