The Quick Ratio is a variation of the Current Ratio, and is also an indicator of a business’s ability to meet its financial obligations. To learn about the Current Ratio, visit our video library at www. CFOoutsource.com. As discussed in the Current Ratio video, the Current Ratio is a number that is derived by dividing current assets by current liabilities. The quick ratio is a more conservative ratio because it subtracts inventory from current assets before computing the ratio. Therefore, the Quick Ratio is a smaller number than the Current Ratio. Where a good current ratio is generally in the range from 2:1 to 3:1, a quick ratio may be a number that is better than 1:1.
Why is inventory subtracted from Current Assets in the determination of the Quick Ratio? It’s because inventory is generally a substantial asset, and it has a longer realization time than other current assets, such as accounts receivables. In most businesses, inventory has to be turned into an accounts receivable at the time it is sold, before it can be turned into cash. In business that do manufacturing, raw materials inventory has to be tuned into finished goods inventory before it can be sold. Additionally, the inventories of businesses are subject to obsolesce and shrinkage, which can make the total stated value of the inventory on the balance sheet questionable.
The Quick Ratio is also sometimes referred to as the Acid-Test Ratio, and the formula is sometimes modified to include only cash, accounts receivable, and short-term investments in the numerator. If maintaining a threshold quick ratio is part of your loan covenants, it’s important to have a good business plan model that predicts more precisely when assets will be realized and obligations are expected to be paid. For more information, visit our video library at www.CFOoutsource.com.