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Lesson 6: Liquidity Ratios, Quick Ratio

Liquidity Ratios, Quick Ratio, Fundamental Analysis

Liquidity Ratios, Quick Ratio, Fundamental AnalysisWe have seen the first Liquidity Ratio, the Current Ratio. Today we go ahead, analysing the following ratio: the Quick Ratio. The Quick Ratio, also called Acid Test Ratio, compares the cash, short-term marketable securities and accounts receivable to current liabilities.

The thought behind the quick ratio is that specific line items, such as prepaid expenses, have already been paid out for future use and cannot be quickly and easily converted back to cash for liquidity purposes.

So this ratio measures the ability of a company to pay its current liabilities when they come due with only quick assets. It is supplementary to the Current Ratio. The Quick Ratio is a more severe and stringent test of a company's ability to pay its short-term obligations as and when they become due. It establishes the relationship between the quick assets and current liabilities.

The Quick Ratio formula is the following:

Quick Ratio, Financial Ratios, Ratio Analisys

 

The major item excluded in the quick ratio is inventory, which can make up a significant portion of current assets but may not easily be converted to cash. During times of stress, high inventories across all companies in the industry may make selling inventory difficult. Also, if company stockpiles are overly specialised or nearly obsolete, they may be worth significantly less to a potential buyer.

Current Assets minus Inventories often take the name of "Quick Assets".

The higher the Quick Ratio, the safer a position the company is in. Indeed, a ratio greater than 1 means that the company has enough quick assets to pay for its current liabilities.

 

Example

A Company has currents assets for $ 80,000, inventories for $25,000, and current liabilities in the amount of $ 30,000. All of this gives a Quick Ratio of 1.83. A ratio of 1.83 indicates that the company has sufficient current assets to cover its current liabilities more than one and a half times (almost two times) over without selling inventory.

Quick Ratio, Financial Ratios, Ratio Analisys

 

The Quick Ratio is very similar to the Current Ratio except that it excludes inventory because inventory is often illiquid. Indeed if a company needed to liquidate inventory quickly, they might be worth a great deal less than the inventory figure it bears on its accounting books.

The next week we will see the Cash Ratio.

 

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