Most business owners focus on long-term financial planning. They want to see what they can accomplish in 3-5 years; how their profits may change and what would be the options for further expansions.
But by constantly looking way too ahead, it’s easy to miss an obstacle just a few steps away from you. So if you want to gain a better understanding of your company’s short-term financial health, consider measuring your quick ratio. Below is your primer on this essential accounting metric.
Quick Ratio Definition
Quick ratio accounting term defines a metric that is used to assess the company’s short-term liquidity (= how much free capital to spend the business has), and its ability to meet short-term financial obligations within the next 90 days – pay supplier invoices, outstanding debt and so on.
Another term frequently used instead of quick ratio is acid test. Why’s that? Back in the day miners used to pour acid over gold to test if it was real. Authentic gold stands up to acid, while other metals that may look like gold turn green. So if your business can’t survive the “acid test”, it’s a clear sign that something’s wrong with your cash flow management.
The aim of this accounting practice is to show how easily your business can be liquidated and helps banks decided whether you are a good candidate for a loan. The easier your business is to liquidate, the more likely you will get approved for a loan.
Quick Ratio Formula
Here’s how to calculate quick ratio for your business:
(Cash + Marketable Securities + Receivables) / Current liabilities
= Quick ratio
Now let’s dwell a bit more on each of the terms in the formula:
Cash: That’s simple. Add up all the dollars you currently have to your business name, plus cash equivalents if any. These include market accounts, certificates of deposits, Treasury bills that mature within 90 days and business savings accounts.
Marketable securities – the dollar worth of all the publicly traded stocks/bonds and commercial papers your business may have issued.
Account receivables – invoices and other incoming payments due within the next 90 days.
Note: The quick ratio formula does not include current assets such as inventory or any other asset which cannot be turned into cash quickly.
Current liabilities encompass all the financial obligations due within one year. The common liabilities are employee salaries, taxes, interest on long-term/short-term debt, insurance, rent etc.
Example of Quick Ratio Calculation
Amazing company Z has $250,000 in quick assets:
- Cash on hand: $50,000
- Cash in the bank: $100,000
- Accounts receivables: $90,000
- Short term investments: $10,000
The current liabilities of that business round up to $70,000:
- Accounts payables: $45,000
- Salaries payable: $20,000
- Interest payable: $5,000
The quick ratio is $250,000/$70,000 approx 3.5. – a very healthy number! This means that the business has $3.5 of liquid assets available to cover each $1 of current liabilities.
What is a Good Quick Ratio Number?
Typically, a quick ratio beyond 1X indicates certain financial issues. If something goes wrong with the business, it will have to sell inventory to raise additional cash and meet its obligations.
A quick ratio above 1X means that the business is doing better. To maintain liquidity it will not have to resort to selling inventory to meet the financial obligations.
However, it’s always best to benchmark the quick ratio results within the context of the business specific industry and its competitors. CSI market suggests the following quick ratio averages per industry:
|Industry||Average Quick Ratio|
At first, it may seem that everyone but the tech businesses is not doing great with a quick ratio beyond 1X. But companies in the retail industry, for instance, tend to negotiate better credit terms with suppliers allowing them to maintain a relatively high current liabilities number compared to liquid assets.
Current Ratio vs Quick ratio – What’s The Difference?
Another accounting term that frequently pops up next to quick ratio is current ratio (also known as a working capital ratio). The formula for it is as follows:
(Cash + Marketable Securities + Receivables + Inventory)/Current Liabilities
= Current ratio
Unlike the quick ratio formula, this one takes the inventory into account. So if some company has a significantly lower quick ratio than current ratio it means that the business is heavily relying on inventory to compensate for few other liquid assets. In other words, if all their payments are due at once, they will not be able to pay them off.
But, it’s important to understand that the current ratio number is just a “snapshot” taken a fixed point in time, and not a full representation of the company’s liquidity. It’s rather volatile and can change month-over-month depending on various circumstances.
For example, a business deals with customers who have notoriously long payment cycles, or worse – are forced to chase up some late payers a lot. So at some point, there may be a lot of aged accounts receivables that are not accounted for in the current ratio. One solution to this issue is to adjust your payment terms.
The Pros and Cons of Tracking the Quick Ratio
As mentioned already, quick ratio offers a way to measure your company’s liquidity and scoop the financial health for the next 90 days. Lenders may also want to know that number before making a decision.
However, using this formula regularly as part of your day-to-day bookkeeping has certain advantages and disadvantages.
The Pros of Using Quick Ratio Formula:
- You receive a short-term outlook on your business health.
- Compared to current ratio, this is a more conservative way of assessing the company’s liquidity (as the inventory is not included in the calculations).
- The quick ratio eliminates business valuation issues, so certain specialists see it as a better way to measure liquidity.
Cons of Using Quick Ratio:
- The formula doesn’t account for the timing of cash flows.
- It also assumes that accounts receivables can be readily collected anytime by the business. But that’s not always the case for most companies.
- You will have to additionally account for things like customer discounts and early payment discounts that will impact your accounts receivable number.
- Using quick ratio alone is not sufficient to analyze the exact liquidity position of the company.
Three Tips for Improving Your Quick Ratio (and Your Financial Health!)
If you’ve decided to stick with using quick ratio, there are several ways to boost your number and your liquidity.
1. Ramp Up Sales & Inventory Turnover
More sales mean higher inventory turnover, leaving you with more cash on hand (and in your bank account). Considering that cash is the most liquid asset you can possess, owning more of it means that you will be able to meet your short-term obligations without much hassle.
Here are a few things you can do to shake up that inventory:
- Try to reduce setup and changeover costs from manufacturers.
- Or negotiate a price cut and drop the prices for your goods.
- Review your current pricing & promotions strategy
- Try a forecasting solution to make better predictions for your stock.
- Eliminate stagnant inventory
2. Improve Invoice Collection Period
If possible, try to reduce the collection period of accounts receivable (invoices). This tip alone can have a massive positive impact on your quick ratio.
But it’s easier said than done, right? Collecting late invoices and negotiating better payment terms is hardly an entertaining process. Here are some of the things that may help:
- During the onboarding process walk every client through your invoicing process, payment terms and so on.
- Introduce a discount scheme for early payments.
- Create an automated payment reminders email sequence to send over before the invoice due date, after and up till the account is paid for.
- Consider hiring professionals to help you with collecting outstanding invoices.
3. Pay Off Liabilities as Soon as Possible
Keeping close tabs on your company’s liabilities is another step towards a better quick ratio. Keeping them low leaves your business with more cash. Hence, consider paying off loans faster than they are due and try to negotiate better repayment terms for your loans.
Quick ratio is a handy accounting formula to know and apply periodically to analyze your company’s health. It may not provide the complete picture, but it does serve as a strong indicator of whether some proactive action must be taken.
And if you want to learn more about some accounting best practices for SMEs, consider checking out our previous posts:
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