Lesson 3 – What is the Quick Ratio? «

Lesson 3 – What is the Quick Ratio?


Learning Goal for Lesson
At the end of Lesson 3, you should be able to calculate and analyze your company using the quick ratio and know something about your company’s liquidity that is more specific than what you learn from the current ratio. This lesson focuses on quick ratio analysis, also called the acid-test.

Synopsis of Lesson 2: What is the Current Ratio?
What is the Current Ratio? is Lesson 2 in this e-course, Financial Analysis Using 13 Financial Ratios. It teaches you how to calculate, analyze, and use the current ratio as the broadest measure of liquidity, also called solvency or marketability, for your company.

Lesson 2: The Quick Ratio
The quick ratio, like the current ratio, measures the ability of the firm to pay its short-term liabilities. The quick ratio is a more specific measure, however. Since inventory is the least liquid of all current assets, the quick ratio looks at the ability of a company to pay its short-term debts without having to sell any inventory to do it.

Calculation of the Quick Ratio (Acid-Test)
Like the current ratio, the quick ratio looks at the ratio of current assets to current liabilities to determine whether or not the company can pay its short-term bills on time? There is only one difference between the quick ratio and the current ratio. In the numerator of the quick ratio, you subtract out inventory.

Here is the calculation of the quick ratio:

Quick Ratio = Current Assets – Inventory/Current Liabilities = ______ X

Remember from Lesson 2, The Current Ratio that current assets are expected to be liquidated within one year and current liabilities are expected to be paid off within one year. In the case of the quick ratio, you subtract out inventory from current assets in order to see if you can pay off your current debts without liquidating any of your inventory.

All the information you need to calculate the quick ratio is included in the balance sheet we are using for this e-course. If you take a look at this balance sheet and the current assets, inventory, and current liabilities, you will come up with the following formula:

$450,000 – $210,000/$180,000 = 1.33X

The quick ratio is 1.33X. This means that XYZ Company can pay its short-term debt without having to sell any inventory. As long as the quick ratio is greater than 1.00X, this is true. If the quick ratio drops below 1.0X, then the company would have to sell inventory to meet its short-term debt obligations. This is not a good thing since inventory is not liquid.

Analysis of the Quick Ratio
The quick ratio for XYZ Company for 2009 is 1.33X, down slightly from the 2008 quick ratio (calculated from the same balance sheet) of 1.66X. From a trend or time-series analysis viewpoint, there is little difference between the 2008 and 2009 ratio though the quick ratio is trending downward. It is clear that the company can pay its short-term debts without having to sell any of its inventory in both years.

Is the XYZ quick ratio too high or low? To answer that question, the business owner wants to look at industry average ratio from a free source like Bizminer or a more complete and comprehensive pay source.

XYZ Company is in the industry sector Utilities and, more specifically, Generation, Electric Power and here are its industry averages.

Looking at the industry averages for XYZ’s quick ratio for 2008 and 2009, you find they were 1.52 and 1.05 respectively. Given this information, perhaps the quick ratio for XYZ was a bit too high for 2008 and 2009, just like the current ratio was too high.

Implications of the Analysis of the Quick Ratio
Companies have to remember that a quick ratio of 1.00 is all that is necessary for them to be in good financial health. As long as they don’t have to face selling inventory to pay their short-term debt, such as from suppliers, they are liquid enough. If their quick ratio is much greater than 1.0, then they are losing money on their investment in assets. Those assets could be invested in short-term, interest-bearing marketable securities that earn income for the firm rather than sitting in an account making the firm more liquid, which isn’t necessary, but dragging down their rate of return.

Why Does a Company Hold Cash?
In Lesson 2 concerning the current ratio and in this lesson, our focus is on calculating the ratios that determine a company’s liquidity and analyzing the results of those ratios. Let’s look at why a firm needs to be liquid or hold cash in its account.

There are several motives for a firm to hold cash:

1.Transactions Motive
The transactions motive for holding cash is simply to pay for expenses associated with day-to-day business operations. Companies have to have money on hand for daily expenses.

2.Precautionary Motive
The precautionary motive for holding cash is so a company will have a safety cushion of liquidity if an emergency happens. A good example would be the Great Recession. After the Wall Street crash, companies that had a safety cushion of cash were better able to withstand the effects of the Great Recession than those who did not.

3.Compensating Balance Motive
Companies should hold cash to deposit as a compensating balance if they have to apply for a bank loan. Most banks require a compensating balance to be held at their bank if they grant a loan. Banks will look more kindly on a company with regard to a bank loan if they have cash on hand.

 

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