One of the most reliable financial formulas used to assess a company's liquidity is the quick ratio calculation, sometimes known as the acid test ratio. In theory, the sale of a company's assets would fully offset any outstanding short-term debt, so that the company can continue to operate. Executive managers, financial analysts, investors, and lenders all rely on the formula as a standard accounting measurement. Fixed or non-current assets, including buildings, property and equipment, are not included in the quick ratio calculation because they are not readily convertible into cash.
Calculating a company's ratio involves dividing the total current assets less the total inventory by the total liabilities. The resulting number or fraction is the quick ratio, which is expressed as a whole or fractional number. A resulting number of 1.0 or greater indicates that the company's liquidity is considered healthy. Fractional ratios typically indicate that the company has some risk of not being able to pay its debts.
When analyzing an organization's financial risks, a quick ratio analysis is considered to be more stringent than the working capital ratio analysis because it is limited to cash and cash equivalents and does not take into account any inventories, fixed assets, or equipment. Even though the quick ratio is a useful measure for determining a company's financial health, businesses with high inventory levels, such as retail stores or restaurants, are at somewhat of a disadvantage when analyzed this way, showing considerably higher risk overall in their solvency profile. Financial analysts typically recommend caution when investing in companies that have a quick ratio that is lower than the working ratio, because it means that the assets are primarily tied up in inventory which may be difficult to liquidate in an emergency.
People who are in a position to lend money to companies use the quick ratio to evaluate whether or not a company would be able to pay off its debts in extreme haste and under the most dire conditions. Also worth noting is the difference in perceiving the value of the quick ratio is role-based. While lenders might prefer to see a cash-to-liability ratio higher than 1.0 because it indicates the company would be more likely to repay a loan if urgency demanded it, the company's shareholders might prefer a cash-to-liability ratio of less than 1.0 because that signals that the company management is using its assets to grow the business.
