What Does the Quick Ratio Tell Us About a Company?
The quick ratio is one of the common ratios used to tell the story of a company's liquidity. Liquidity is your ability to quickly generate cash to cover short-term liabilities in a pinch. Along with the quick ratio, the current ratio and cash ratio are part of the liquidity picture.
The quick ratio is calculated by subtracting your inventory from your total current assets and dividing that amount by your total current liabilities. All of the variables of the liquidity ratios come from your balance sheet. Total current assets include cash and other items easily turned into cash in the near-term. Inventory is the value of the materials or resale products you currently own. Total current liabilities is the amount of debt you must repay within the next 12 months. As an example, a total current assets amount of $110,000 minus inventory of $35,000 equals $75,000, divided by total current liabilities of $100,000 gives you a ratio of 3:4.
The general point of the quick ratio and other liquidity ratios is to show your company's near-term financial security. Solid ratios show you have the ability to keep up with short-term debt obligations. This is important to potential investors and creditors, because it means you are at less risk of being overwhelmed by debt in the near-term. This improves your chances of getting a loan with favorable terms. The quick ratio specifically removes inventory from the current ratio, which compares all current assets to current debts. The point is that liquidating inventory is not practical for long-term business viability.
The ideal quick ratio is right around 1:1. This means you have just enough current assets to cover your existing amount of near-term debt. A higher ratio is safer than a lower one because you have excess cash. The drawback of maintaining a high quick ratio is that you may not be making effective use of your cash to grow your business. Companies sometimes keep cash safety nets when they can't get short-term loans.
A low quick ratio is generally a more risky position since you don't have adequate current assets, without inventory, to cover near-term debt. This also means you rely heavily on efficient inventory turnover to keep you afloat in the short-term. A significant downturn in sales could leave you in a bind. A low ratio also causes concern with potential investors and creditors because of your short-term risks.