Quick Ratio – Definition, Explanation and Proper Use
The quick ratio is a formula used in business to identify the ability of a business to pay its current liabilities. It is also known as the ‘Acid Test’ formula (ratio). In the large markets this formula is one of the industry ratios used to value the stock of a corporation. In the arena of the small business, you should only use this ratio as a means to gauge ability to pay your bills right now.
This article will define the term along with other similar terms; explain the meaning of the term and how you should properly use the term in your business operation.
If you lined up 200 professional financial experts (me included) and ask if anyone thought this term WAS NOT important in the small business world to step forward, I would be one of a few if the only person to step forward. And I would take a HUGE step forward. As you read this article you will begin to understand that its value only begins to increase if you modify the definition to suit the small business owner. The text book definition is designed for large publicly traded businesses. If your company is publicly listed on any of the stock markets, well then, don’t read this article. You are wasting your time.
Quick Ratio – Definition
Remember I stated above that the ratio is also defined as the ‘Acid Test’. There is some history in this. You see, for centuries, currency didn’t exist. Gold was the medium of exchange. For those of you that don’t know, gold does not dissolve in many acids. Pretty cool huh? To test whether the buyer had the ability to pay for the goods, his gold payment was dropped into acid to see how pure it was; thus the ‘Acid Test’.
Well, in business we are doing the same thing. We want to know how pure the ability of the business to pay for its purchases. Thus, we use the term Quick Ratio. This term is used to describe the capability of a company to pay its current liabilities with the existing pool of current liquid assets. The core definition is (Current Assets less Inventory) divided by Current Liabilities. Seems simple enough, but it gets more convoluted as you begin to define those two terms (current assets and current liabilities). The reason inventory is subtracted from the pool of current assets is because the likelihood of it being turned into cash immediately is nearly zero.
You see, quick ratio is a shorten version of another ratio customarily used in business called the Current Ratio which is total current assets divided by total current liabilities. This means all current assets (cash, receivables, inventory, short-term investments, prepaid expenses) are divided by the current liabilities (accounts payable, credit cards payable, lines of credit, accrued expenses, payroll and regular taxes due, short term portion of long term debts, etc.). If you need help in understanding these two terms (current assets and current liabilities), I suggest you read the following two articles:
From this information, you can deduce that the quick ratio takes only the cash and receivables components of current assets to pay the current liabilities. With business analysis, this ratio should always be lower than the current ratio. This is because the current ratio uses a greater value (includes the inventory dollar amount) as the numerator in the formula: NUMERATOR/DENOMINATOR.
Ok, now that you understand this basic definition, it is time to expand the definition. First is the issue of defining cash. In Generally Accepted Accounting Principles (GAAP), cash is defined as all cash in the bank plus any marketable securities (investments that can be sold quickly). If your business operation carries cash in the bank accounts plus various investments such as Certificates of Deposit, Treasury Certificates or Bonds, and/or market instruments such as stocks, options and others; you should include these as cash.
The problem with this is that it takes time (mostly several days) to turn the investments into actual cash. The key to the Quick Ratio is that we want to know right now, this very moment as to the value of the ability to pay the bills. It would seem to me that the investments component should not be included unless you can cash it right now.
The second issue concerns receivables. In the quick ratio, receivables should be included. However, every industry and business is different in how they generated those receivables and the associated collection pattern. Again, I emphasize the importance of the meaning of the quick ratio; it is the ability to pay your bills RIGHT NOW! Not tomorrow or the next day, RIGHT NOW! So to me, receivables will be collected over several weeks and thus it can’t possibly be turned into cash right now.
The third issue addresses prepaid expenses. Technically, you have already paid a bill that isn’t even due nor incurred. It is the same thing as if that vendor owes you something. The most common example of this is prepaying insurance. In most industries, the insurance payment is for the upcoming year. Therefore, the insurance company owes you protection for the upcoming year. We all do this in our normal lives. We prepay our house insurance for the upcoming year because the mortgage company requires this to protect the investment in case of default. You are always twelve months ahead in your homeowner’s insurance policy.
Many so called authorities advocate not including this number in the numerator for the quick ratio. I believe it should be subtracted from the denominator (the current liabilities value) because you have already paid the vendor. Allow me to illustrate the impact this one single number can have on the quick ratio. Example:
Let’s make some assumptions:
Accounts Receivable 10,600
Prepaid Expenses 5,700
Total Current Assets $42,200
Accounts Payable $7,500
Credit Cards 3,750
Accrued Expenses 2,900
Current Portion of Debt 8,400
Total Current Liabilities $24,900
If you use the basic definition as described above, the prepaid expenses are used in the numerator and thus the formula and ratio are as follows:
Formula = $29,000 ($42,200 less inventory)
Quick Ratio = 1.16 to 1
If you subtract the prepaid expenses from the current liabilities as I believe you should, let’s see how the formula and the ratio are different.
Formula = $23,300 ($42,200 less inventory less prepaid expenses)
$19,200 ($24,900 less $5,700 of prepaid expenses)
Quick Ratio = 1.21 to 1
A 1.21 ratio is superior to the 1.16 ratio. This is because the mathematical effect is greater upon the denominator than on the numerator.
The example above illustrates precisely the effect a single value has upon the ratio. The key is what to include and what not to include in the definition of the term. Remember from above that I said I would be one of the few financial professionals to step forward if asked about the value of this term in the small business world. I would further state that if each professional were asked to define the term, out of the two hundred asked, you would get 20 different definitions. But the most common response will be ‘Current Assets less Inventory’ divided by Current Liabilities.
For those of us that understand the value one component has in the formula, I would state that it is irrelevant in the small business world and it only becomes important when the values get larger as found in publicly traded companies. In those companies, the numbers become so large that any small discrepancy in the formula has very little to no effect on the final ratio.
Quick Ratio – Explanation
The long winded definition from above is shortened to Quick Ratio equals current assets less inventory divided by current liabilities. This is the textbook definition. Just for fun, I looked it up in one of my old accounting books. This is the most commonly used format and if you searched the internet or so called business manuals, they just regurgitate the same definition.
The reality is that the term should be defined based on its purpose. To me, the quick ratio is the ability to pay your existing bills right now without resorting to other sources of cash. This means the ability to pay how much of your current liabilities without having to borrow money or have additional equity invested into the business.
If you have a one to one ratio, you can pay all of your existing bills. Any ratio greater than one to one such as the examples above means you’ll have current assets left over! But the quick ratio is about the ability to pay the existing bills. Your vendors don’t want to get paid with accounts receivable nor do they want some stock, they want CASH. So cash should be the only item in the numerator (the top half of the ratio).
The same goes for the bottom half. Defining the denominator is just as important. Accounts payable is definitely included in this number. But the current portion of long term debt includes those principle portions of payments 2 to 12 months out from now. So you don’t need to include current portion of long term debt in your denominator. Current portion of long term debt doesn’t need to be paid right now.
Allow me to discuss the rationale with the other line items.
- Credit Cards – these are just like vendor payables, the only difference is that you used an indirect third party to finance the purchase. The amounts due are those within the traditional accounting cycle.
- Accrued Expenses – this is one of those, it depends line. Sometimes the associated accrued expenses relate to some form of a payment due in many months or at year end. But if the accrued amount relates to something due within 30 days, you should include that dollar value as part of the denominator.
- Payroll – yes, include this number
Based on this, my definition of the quick ratio equals:
All Cash (no investments, receivables, prepaid etc., just cash)
All Current Liabilities less Current Portion of Long Term Debt less Prepaid Expenses
What do you get? A value that states your ability to pay your bills right now, not tomorrow, not next week, RIGHT NOW. Now this is going to change tomorrow morning once the mail arrives and one of your customers pays their invoice from you. Your cash goes up, and so does your ratio.
This fact should leap out at you. The quick ratio is only a moment in time. It is right now. The cash account will change tomorrow or in a few days when you make payroll or have some other influx of cash. This is why I am convinced it has little to no value for the small business owner. In large businesses, they will use the textbook definition and so if a customer pays, it doesn’t really change the ratio (receivables are included in the formula). The numerator has no change. Since publicly traded businesses work with large numbers, it takes several weeks to make any identifiable change in the quick ratio. Their only exception is if there is an equity investment or borrowing via long term debt (bonds) to add cash to the numerator.
Now I stated above that I do not believe the quick ratio has any real use for the small business owner. However, you can use the formula to help you identify possible issues with operations. Allow me to explain the proper use of the formula.
Quick Ratio – Proper Use
Remember, the quick ratio is really nothing more than the ability to cover current bills with cash right now. The higher the ratio; the better able you are to pay your bills. It is like a warm blanket on a cold night, the more cash you have, the thicker the blanket and the more comforting the feeling.
As the owner of the business, you should be looking at your cash flow issues regularly. At least weekly, you should sit down and figure out the cash situation. You want to know, how much do I have and how much is due out to vendors, employees, and credit accounts. An easy number to use is the quick ratio. If your ratio is greater than 1:1 then you are in great shape. If less than 1:1, it is time to look at sources of cash to make sure the bills get paid.
Ultimately, you would love to have an extremely high ratio like a 5:1 or more. This is really where you want to operate. However, in some industries this will be tough to achieve and in rare situations, it isn’t a good idea to carry large amounts of cash. Examples include those businesses where profits are extremely high and there is no desire to expand operations. Therefore, it is a good idea for the owner to take the cash out of the company and invest his money at the private level.
In some business environments, it is not uncommon to have a very low ratio from time to time. In these environments, the business puts up a lot of cash up front and carries a current asset known as Work in Process (an inventory account); in effect the cash is invested in some project of some sort. Once the project is complete, the item is sold and the cash account has a large influx suddenly. Then the process starts all over. Examples of this include those involved in construction, real estate development, site development, subcontractors and so on.
The following are some general rules for you related to using the quick ratio:
- Don’t compare your business quick ratio to somebody else’s ratio unless you are in the same industry, serving the same customer and selling the exact same products. Even in this situation it isn’t a fair comparison because it is nothing more than a moment in time. One day makes can make a big difference in the cash balance on the books. See the next rule.
- Moment in time – Remember, the quick ratio is just a moment in time and therefore it changes constantly. So when your competitor or somebody else uses the term in communicating with you about their financial information, you should immediately recognize that their ratio could have been easily influenced by some other business action, such as borrowing money from the bank (cash goes up, long term debt goes up) or the owner made some type of equity investment. The reality is that small business owners should never use the quick ratio when talking about their respective financials with others.
- Warning system – Use the ratio to establish a warning system. At some point in the ratio analysis, a certain low point should act as a warning sign that you need more cash to deal with current liabilities. Something is going on and you need to figure out why cash is getting consumed. It is possible that you may have an increase in sales due to your seasonal nature and therefore, receivables go up. When receivables go up, often cash goes down. You have to buy new goods to replace those goods purchased via normal customer receivables. This is actually a good thing because you are selling product, however, you may not have enough cash on hand to continue operations without some outside cash inflow. You may have to borrow money on a short term basis.
- Track your ratio from week to week using a spreadsheet and think about the items that make a significant change in the ratio as you progress from period to period. The key is to understand the dynamics of your business. This ratio gets you thinking about cash and how to get it the bank account. In addition, it makes you realize that sometimes certain purchases can wait. Instead of having your office supplies credit account increase, you can defer the purchases to a later date. The key to the ratio is that it makes you think as an owner. In the small business world, this is the greatest value for the owner of the business.
- Banking – On the last day of your business year, get your bank account balance as high as possible. This means taking your own money and temporarily investing those funds into your business. Why? Because of the banks. Banks are notorious for their rigid rules and performance evaluations. If you take your personal cash and place those funds into your business account on the 2nd to the last day of the year and offset that with the equity accounts, you get FIVE great positive attributes to your business operation. These include:
- A higher Quick Ratio – see above to understand this concept
- A higher Current Ratio – in essence, the same as the Quick Ratio
- A great looking bank balance at year end which makes the bank smile and future buyers smile too
- A higher Equity Position – this makes the bank happy and makes your balance sheet look much better
- A better looking Balance Sheet – future readers of your balance sheet will be impressed
Now this may seem like cheating in some way, but there is no law against it and honestly, I don’t make the rules, I just understand them. In the 19 years of professional accounting services, I have yet to meet a banker that could think on their own. They follow very rigid and strict guidelines to interpreting business performance. Cash in the bank on the last day of the year seems to carry a lot of weight in future decision models if applying for a loan or some form of financing. Buyers of businesses look at this dollar value in evaluating a business. Me, I understand that the balance sheet is nothing more than a snapshot of a moment in time. For some reason other professionally educated and so called experienced people place a tremendous amount of credence on some numbers on a piece of paper at the last moment of your fiscal/calendar year. Use this knowledge to your advantage.
On January 2nd, go get your money back out the business account and have a nice day!
Summary – Quick Ratio
The quick ratio or also known as the ‘Acid Test’ is a formula evaluating a business’s ability to pay their current liabilities at this very moment. The text book definition is current assets less inventory, divided by current liabilities. I explain that the formula has very little merit at the small business level due to its definition. However, if you modify the formula as straight cash against current liabilities, you get a picture of your ability to pay your bills right now. This is a better definition for the small business owner because in the small business world, you need to know your cash situation and your ability to meet your cash needs today. The modified quick ratio is a great tool to use in understanding your cash position.
Please do not use this tool to compare your business to someone else’s operation. The numerator is easily influenced by too many variables to warrant its use in comparing operations. You should use the quick ratio as a barometer of your business provided you monitor the quick ratio from week to week. Finally, use the tool to your advantage by tracking the ratio and using it as a warning tool. Act on Knowledge.