What it means
The current ratio compares all current assets with current liabilities, but current assets are not all equally available. Cash can be spent today.
Receivables will become cash within weeks if customers pay. Inventory must first be sold, and sold at a price close to book value, which is not guaranteed for slow-moving, seasonal or specialised stock; and prepaid expenses cannot be converted to cash at all.
The quick ratio removes those two items and asks a sharper question: if every bill fell due now, and no more stock could be sold, could the business pay? Interpretation depends on the business.
A supermarket with cash sales and fast-moving stock can run a quick ratio well below 1.0 safely, because inventory turns into cash within days and suppliers are paid weeks later. A machinery maker whose stock takes months to build and sell needs a higher ratio.
A ratio persistently below about 0.5 in a business that is not a cash-and-carry retailer usually means the company depends on selling stock or rolling over credit to pay its way, which is fragile. A ratio far above 1.5 may mean cash is sitting idle or receivables are not being collected.
The ratio is only as good as the receivables in it. Amounts owed by customers who will not pay are not quick assets, so analysts adjust for doubtful debts and look at the receivables ageing.
Similarly, a quick ratio measured on the balance sheet date may not represent the rest of the year: businesses can time payments and collections to flatter the figure at year end, which is why lenders often ask for monthly or quarterly ratios rather than an annual snapshot. Alongside the current ratio and the cash ratio (cash alone divided by current liabilities), the quick ratio forms a ladder of increasingly strict liquidity tests.
Reading all three shows not just whether the business can pay its bills but how much it depends on stock and on customers to do so.
In practice
Real-world examples.
Example
A software company with no inventory has a quick ratio of 2.1, identical to its current ratio, reflecting a cash-rich business with subscription customers who pay in advance.
Example
A car dealership has a quick ratio of 0.3 because most of its current assets are vehicles on the forecourt; its bank accepts this because the stock is financed by a floor plan facility secured on the cars themselves.
Example
A clothing retailer's quick ratio falls from 0.9 to 0.4 after a poor season leaves it with unsold stock and a large payable to its overseas supplier.
Think of it
“The quick ratio is like checking if you can pay bills using just cash and money owed to you, without selling stuff.
Formula
Calculation
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
or equivalently: (Current Assets minus Inventory minus Prepaid Expenses) / Current Liabilities
Worked example. A wholesale distributor of building products has the following at year end:
- Cash: $150,000
- Short-term investments: $50,000
- Accounts receivable: $900,000 (of which $120,000 is more than 90 days overdue and doubtful)
- Inventory: $1,300,000
- Prepaid expenses: $60,000
- Current liabilities: $1,400,000
Quick ratio = ($150,000 + $50,000 + $900,000) / $1,400,000 = $1,100,000 / $1,400,000 = 0.79
Adjusted quick ratio (excluding doubtful receivables) = ($150,000 + $50,000 + $780,000) / $1,400,000 = 0.70
Current ratio for comparison = ($150,000 + $50,000 + $900,000 + $1,300,000 + $60,000) / $1,400,000 = $2,460,000 / $1,400,000 = 1.76
Cash ratio = ($150,000 + $50,000) / $1,400,000 = 0.14
The current ratio of 1.76 looks healthy, but the quick ratio shows that without selling stock the distributor could pay only 70% to 79% of what it owes. Whether that is a problem depends on how quickly its stock sells: at an inventory turnover of eight times a year (45 days of stock) it is comfortable; at three times a year it is exposed.Case study
Seen in the real world.
A specialist engineering firm applied to its bank for a working capital facility, presenting a current ratio of 2.2. The bank's credit analyst calculated the quick ratio at 0.45. Two thirds of the firm's current assets were work in progress on long-term contracts, which would convert to cash only when milestones were certified, some of them a year away, and could not be sold to anyone else.
Receivables included $400,000 in dispute with a client. The analyst concluded that the firm's ability to pay its suppliers depended entirely on the timing of client certifications, which the firm did not control.
The facility was approved, but only with a covenant requiring a quick ratio above 0.6 measured quarterly, and the firm responded by negotiating stage payments on new contracts and invoicing certified work within 48 hours. Two years later its quick ratio stood at 0.9 and the covenant was relaxed.
Watch out
Common mistakes.
- Treating all receivables as quick assets. Overdue and disputed amounts should be excluded.
- Applying one benchmark to every industry. Cash-sales retailers live safely on low quick ratios; project businesses need higher ones.
- Reading a single year-end figure. Liquidity ratios can be managed on one date; look at the trend and at interim figures.
Questions
People also ask.
What is a good quick ratio?
Around 1.0 is a common benchmark, but the right level depends on how quickly inventory turns and how reliable customer payments are.
Why is it called the acid test?
From the practice of testing gold with acid: a quick, decisive test of whether something is what it claims to be.
What is the difference between the quick ratio and the current ratio?
The current ratio includes inventory and prepaid expenses; the quick ratio excludes them and so measures liquidity without depending on stock being sold.
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