Quick Ratio (Acid-Test Ratio) is ratio between the most liquid assets and Current Liabilities. It compares Current Assets without Inventories with Current Liabilities of the business. Quick Ratio (Acid-Test Ratio) is similar to Current Ratio except it ignores stock when measuring liquidity.
Liquidity is the ability of a business to pay its short-term debts – its access to cash. If a business does not have enough cash to pay for its immediate expenses (or short-term debts), it will not be able to continue trading. Therefore, liquidity is important to a business’s survival and smooth daily operations. Hence, it must be carefully managed at all times.
What does Quick Ratio (Acid-Test Ratio) measure?
Quick Ratio (Acid-Test Ratio) deals with the firm’s most liquid assets and Short-term Liabilities – it excludes Inventories from Current Assets. It reveals whether a firm is able to cover its short-term debts using its most liquid assets such as Cash and Debtors (Accounts Receivable).
Current Assets represent things owned by the business which are already in the form of Cash, or which are easy to be converted into cash within the next 12 months. Current Assets are important to a business because they indicate how much cash a business has access to in order to meet its short-term obligations. Current Liabilities are the short-term debts of a business, which are expected to be paid in the near future within the next 12 months.
It is important that the level of Current Assets is greater than the level of Current Liabilities. Otherwise, the business risks liquidity problems – not having enough cash to pay its short-term debts, nor any spare cash for unexpected daily expenses.
The main problem with Current Ratio as a measure of liquidity is that some assets are more difficult to turn into cash than others. Therefore, Quick Ratio (Acid-Test Ratio) is a more meaningful test of a firm’s liquidity because Inventories not always easily nor quickly converted into cash. In fact, Inventories are the least liquid of the firm’s Current Assets because:
- Unique raw materials may be impossible to resell due to lack of customers. So, there is no certainty whatsoever that those Inventories will ever be sold.
- Work-in-progress does not have much value added to fetch a very good price.
- Finished goods have to be sold to customers which the business does not yet have. When finished goods are sold using trade credit, the business has to wait for the payment.
Therefore, by eliminating the value of Inventories from Quick Ratio (Acid-Test Ratio), business stakeholders are given a clearer picture of the firm’s liquidity – the real ability to pay short-term debts.
Quick Ratio (Acid-Test Ratio) measures whether a business is able to cover its short-term debts using its most liquid assets such as Cash and Debtors (Accounts Receivable).
How to calculate Quick Ratio (Acid-Test Ratio)?
The figures for working out Quick Ratio (Acid-Test Ratio) can be found in Balance Sheet:
| Current Assets – Inventories | |||
| Quick Ratio (Acid-Test Ratio) = | ━━━━━━━━━━━━━━━━━━━━ | ||
| Current Liabilities |
Current Assets include Cash, Debtors (Accounts Receivable) and Inventories.
Current Liabilities include Overdraft, Creditors (Accounts Payable), Short-term Loan, TAX and Dividends.
Comment
Quick Ratio (Acid-Test Ratio) is expressed as a number.
A ratio of 2.5 implies that the firm has USD$2.50 of Cash and Debtors (Accounts Receivable) to cover every USD$1.00 of Current Liabilities.
Proper Quick Ratio (Acid-Test Ratio): Quick Ratio (Acid-Test Ratio) of at least 1 is generally satisfactory. Otherwise, the firm might experience working capital difficulties, or even a liquidity crisis. Liquidity crunch is a situation where a firm is unable to pay its short-term obligations. Quick Ratio (Acid-Test Ratio) should be no greater than 2 since this suggests that the business has too much cash tied up in unprofitable assets. Potential lenders, suppliers and investors are likely to be interested in a firm’s Quick Ratio (Acid-Test Ratio) to reduce the exposure of risk, since this ratio measures the ability of a firm to cover short-term debts with its Cash and Debtors (Accounts Receivable).
Too low Quick Ratio (Acid-Test Ratio): If Quick Ratio (Acid-Test Ratio) is below 1, then the short-term debts of the business are greater than its most liquid assets. This could jeopardize survival of the business, if all creditors demand payment at the same time, as there is a risk of the firm not having enough Cash to pay its Long-term Liabilities. A low ratio might lead to corrective management actions to increase cash held by the business.
Too high Quick Ratio (Acid-Test Ratio): A Quick Ratio (Acid-Test Ratio) above 2 suggests that there is too much Cash and too much Debtors (Accounts Receivable) – too many funds are tied up in unprofitable assets. Cash could be better spent to generate more sales and too many debtors increase the likelihood of bad debts. These assets should be better placed to increase efficiency.
Example for Quick Ratio (Acid-Test Ratio)
COMPANY A
Company A has Current Assets of USD$1,500,000 and Current Liabilities of $1,000,000 in 2020. In 2021, Company A has Current Assets of USD$1,600,000 and Current Liabilities of USD$800,000.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Current Assets | $1,500,000 | $1,600,000 | |||||
| Cash | $1,000,000 | $600,000 | |||||
| Debtors (Accounts Receivable) | $300,000 | $900,000 | |||||
| Inventories | $20,000 | $100,000 | |||||
| Current Liabilities | $1,000,000 | $800,000 | |||||
| Overdraft | $100,000 | $50,000 | |||||
| Creditors (Accounts Payable) | $500,000 | $450,000 | |||||
| Short-term Loan | $250,000 | $200,000 | |||||
| TAX | $100,000 | $100,000 | |||||
| Dividends | $50,000 | $0 | |||||
| Current Ratio | 1.5 | ➚ | 2 | ||||
| Quick Ratio (Acid-Test Ratio) | 1.3 | ➚ | 1.9 |
For every USD$1 of Current Liabilities, Company A has USD$1.3 of Current Assets excluding Inventories in 2020. In 2021, for every USD$1 of Current Liabilities, Company A has USD$1.9 of Current Assets excluding Inventories. This means that the company is more liquid in 2021 comparing with 2020 as it has access to more of the most liquid assets such as Cash and Debtors (Accounts Receivable) to meet its Short-term Liabilities and pay any unexpected expenses without the need to sell any Inventories.The company is showing an improvement in liquidity.
The closer Current Ratio and Quick Ratio (Acid-Test Ratio) are to one another, the lower the inventory level the company holds. The farther Current Ratio and Quick Ratio (Acid-Test Ratio) are to one another, the higher the inventory level the company holds.
How to improve Quick Ratio (Acid-Test Ratio)?
Quick Ratio (Acid-Test Ratio) can be improved by a combination of raising the value of the most liquid Current Assets, specifically Cash or Debtors (Accounts Payable), as well as reducing the value of Current Liabilities.
Ideally, the business wants to increase its Cash. However, there is also a potentially large opportunity cost in holding too much Cash.
- Increase Cash:
- Sell off Inventories. This will improve Quick Ratio (Acid-Test Ratio), but not Current Ratio. Inventories, work-in-progress and finished goods could be sold off at a discount to raise cash. However, this will reduce Gross Profit Margin (GPM). Also, inventories might be needed to meet changing customer demand levels. And, some consumers may doubt the image of the brand, if inventories are sold off cheaply.
- Sell off Fixed Assets. Unused land and buildings as well as redundant equipment could be sold. The business could also lease them back, if still needed. However, leasing charges will add to Expenses (Overheads) and reduce Net Profit Margin (NPM). If Fixed Assets are sold quickly, they might not raise their true value.
- Increase long-term loans to inject cash into the business. Long-term bank loans could be taken out, if the bank is confident of the company’s prospects. However, these will increase interest costs and Gearing Ratio.
- Sell shares. New investors will inject much-needed cash into the business in exchange for partial ownership.
- Delay payments to Creditors. It might be possible to negotiate delayed payment to creditors with whom the business has trustworthy relationship.
Can the firm increase Debtors (Accounts Payable)? It can be dangerous for a firm to increase Debtors (Accounts Payable) since this increases the likelihood of bad debts.
2. Decrease Current Liabilities:
Hence, it is more practical for a business to reduce its Short-term Liabilities.
- Decrease Overdraft. Convert Overdraft with very high interest into long-term debt that offers more attractive rates of interest. However, this option may affect the long-term liquidity of the firm.
- Decrease Creditors (Accounts Payable). Temporarily halt purchasing new Inventories using trade credit.
- Decrease Short-term Loan. Convert short-term bank loans with high interest into long-term debt that offers more attractive rates of interest. However, this option may affect the long-term liquidity of the firm.
- Decrease TAX.
- Decrease Dividends. Cancel or reduce the cash that is paid out to shareholders in the form of a dividend. Instead of transferring the cash to shareholders, the business can keep it to improve Current Assets.
