What Is the Quick Ratio?
The quick ratio, also known as the acid test ratio, is a measure of a corporation's ability to pay down current liabilities using liquid assets — assets that can be quickly converted into cash. This would consist of things like cash, marketable securities, short-term investments, and accounts receivable. Basically, it's a good indication of whether a company is in good financial standing or has taken on more debt than it should have over a short-term period.
Why Are Quick Ratios Important?
Quick ratios are crucial for businesses that want to remain financially sound and appear that way to outsiders. Both in public and private markets, investors will pay attention to quick ratios to determine if they can expect to make a return. While a quick ratio below 1:1 isn't always a red flag, it is usually worth examining further to ensure it is made up for elsewhere, typically through rapid growth rates.
Quick ratios also tell a company whether it needs to raise more capital or not. Taking on overarching short-term debt without a plan to pay it back is extremely dangerous. All businesses are susceptible to black swan events that can take place overnight. In extreme circumstances and without preparation, they can be wiped out entirely. Gold's Gym and Hertz were two big names that already had poor financial management before COVID-19, but subsequently, they were forced to file for bankruptcy during the pandemic due to lack of liquidity.
What Is a Good Quick Ratio?
A good quick ratio is one where companies should be able to cover all short-term debt using their liquid assets. A quick ratio that is 1:1 or more would satisfy these conditions. In an ideal situation, a business would have more than enough to cover its debt, and it would have extra liquidity on hand. For example, a 2:1 quick ratio would mean a company could cover all its current liabilities and have ample liquidy leftover for other business expenses such as research and development.
How To Calculate a Quick Ratio
The most common quick ratio calculation is defined as follows:
Quick ratio = (cash and cash equivalents + marketable securities + account receivable) / current liabilities
Another way some businesses choose to calculate the quick ratio is:
Quick ratio = (current assets - inventory - prepaid expenses) / current liabilities
Common Pitfalls When Analyzing Quick Ratios
Although a good measure of financial health, quick ratios can sometimes be deceiving. Measures that should also be analyzed alongside quick ratios are profitability and growth. For example, Robinhood has more than enough cash to cover its short-term debt obligations, suggesting it's in a stable position. However, the company is unprofitable and is burning substantial amounts of cash each quarter, thus increasing its risk rating.
The opposite is true for companies growing sustainably like Amazon. It has a quick ratio of less than 1:1, but it has been generating significant profits for several years, lowering its risk.
Quick ratios are a very basic metric to get a quick understanding of a business. However, more often than not, further investigation is required to get a complete picture of financial strength.