Financial Ratios Series – Liquidity Ratios Part 3

Financial Ratios Series Liquidity Ratios Part 3

“Go to bed a little wiser than when you woke up.” Charlie Munger

Quick/Acid Test Ratio

The quick ratio, or also known as acid test ratio, is very similar to the current ratio. The main difference is that it is a more conservative ratio. It means that instead of looking at all the current assets of a company, we look at the most liquid of the current assets. By most liquid, I mean the assets that can be very easily converted into cash.

Current assets is comprised of the following accounts: Cash and equivalents, marketable securities, accounts receivable, inventory, and prepaid assets. From all of these current assets, we exclude inventory and prepaid assets from the quick ratio calculation. This leaves us with the most liquid assets: Cash & equivalents, accounts receivable, and marketable securities.

Now that we have singled out the most liquid of assets, we take their sum and divide it by total current liabilities. Why do we do this? To measure if a company has the ability to pay all of its current liabilities with only its most liquid assets.

For instance, if a company has a high current ratio, but a very low quick ratio, it could indicate that a very high portion of its current assets are tied in inventory. This can be a cause of concern if sales are slow leaving cash tied up in inventory for too long.

The formula to calculate the quick, also called acid test, ratio is:

Quick/Acid Test Ratio = (Cash & Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities 

Do you have any questions? Could I help clarify a particular point? Don’t hesitate to post your comments/questions below. I will respond to you promptly.

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