Learning Outcomes
- Calculate the common variations of the current ratio
The Quick Ratio, sometimes called the Acid Test Ratio, measures the firm’s ability to pay its current liabilities with its cash and other current assets that can be converted to cash within an extremely short period of time. Quick assets include cash, accounts receivable, and marketable securities but do not include inventory or prepaid items.
The calculation for the quick ratio is as follows:
[latex]\dfrac{\text{quick assets}}{\text{current liabilities}}[/latex]
For example: [latex]\dfrac{373,000+248,000+108,000}{364,000}=2.0[/latex]
| 2019 | |
|---|---|
| Assets | |
| Subcategory, Current assets: | |
| Cash | $373,000 |
| Marketable securities | 248,000 |
| Accounts receivable | 108,000 |
| Merchandise Inventory | 55,000 |
| Prepaid insurance | 127,000 |
| Total current assets | Single Line$911,000 |
| 2019 | |
|---|---|
| Liabilities | |
| Subcategory, Current liabilities: | |
| Accounts payable | $120,000 |
| Salaries payable | 244,000 |
| Total current liabilities | Single Line$364,000 |
For Jonick, quick assets are cash, marketable securities, and accounts receivable, and so he calculation is:
[latex]\dfrac{(373,000 + 248,000 + 108,000)}{364,000}=\dfrac{729,000}{364,000}=2.00274725…[/latex]
After rounding, we can see that this company has 2.0 times more in its highly liquid current assets, which include cash, marketable securities, and accounts receivable than it has in current liabilities. The premise is these current assets are the most liquid and can be immediately converted to cash to cover short-term debt. Current assets such as inventory and prepaid items would take too long to sell to be considered quick assets.
A quick ratio is judged as satisfactory on a relative basis. If the company prefers to have a lot of debt and not use its own money, it may consider 2.0 to be too high—too little debt for the amount of assets it has. If a company is conservative in terms of debt and wants to have as little as possible, 2.0 may be considered low—too little asset value for the amount of liabilities it has. For an average tolerance for debt, a current ratio of 2.0 may be considered satisfactory. The point is that whether the quick ratio is considered acceptable is subjective and will vary from company to company.
Compare the quick ratio to the current ratio of 2.5. The quick ratio indicates that for every dollar of debt coming due within the next 12 months, there was $2 of highly liquid assets. The current ratio indicates that there was $2.50 of current assets, both highly liquid and slightly less liquid, to cover every $1 of current liabilities.
The quick ratio will always be more conservative than the current ratio.
Most industries should have acid test ratios that exceed 1:1 (indicating a dollar of quick assets for every dollar of current liabilities). However, very high ratios are not necessarily a positive thing. High acid test ratios could indicate that cash has accumulated rather than being reinvested, returned to owners/shareholders, or put to productive use.
PRACTICE QUESTION
