Quick Ratio: Calculations, Examples, and Meaning

The Quick Ratio, commonly known as the “acid-test” ratio, is normally defined as (Cash & Cash-Equivalents + Accounts Receivable) / Current Liabilities, and it captures a company’s ability to service its short-term obligations using its most-liquid assets.

The Quick Ratio, commonly known as the “acid-test” ratio, is normally defined as (Cash & Cash-Equivalents + Accounts Receivable) / Current Liabilities, and it captures a company’s ability to service its short-term obligations using its most-liquid assets.

The Quick Ratio is an example Liquidity Ratio; like the others, it measures the company’s operational and credit risk.

It is more stringent than the Current Ratio, so it is more useful for “stress testing” the company, as it excludes short-term assets that are more difficult to convert into Cash, such as Inventory.

Files & Resources:

Liquidity Ratios – Slides (PDF)

Liquidity Ratios – Extracts from Illinois Tool Works Filings (PDF)

Illinois Tool Works – Liquidity Ratio Analysis (XL)

Video Table of Contents:

1:39: Part 1: The Top 3 “OG” Liquidity Ratios
4:00: Part 2: Unofficial Liquidity Ratios
8:25: Part 3: Liquidity Ratios in Real Life for Illinois Tool Works
10:44: Recap and Summary

What is the Quick Ratio?

Quick Ratio Definition: The Quick Ratio equals a company’s (Cash & Cash-Equivalents + Accounts Receivable) divided by its Current Liabilities. It indicates whether a company can adequately meet its short-term funding obligations using its most-liquid assets. Higher ratios are generally better, but if the ratio is too high, it could indicate that the company is mismanaging its Cash.

Quick Ratio Formula & Meaning

 

As with the other Liquidity Ratios, the Quick Ratio is important mostly in context.

For example, has the company’s Quick Ratio declined significantly in the most recent few quarters? How does it compare to its historical levels and comparable companies in the industry?

If the Quick Ratio was elevated for a few years, is there a specific reason why? Is the company actually better off with a slightly lower Quick Ratio because it is using some of its Cash to re-invest in its business?

You can see an example of the calculation for Illinois Tool Works [ITW] below (see the Excel file and filing PDF above):

Liquidity Ratios - Quick Ratio

The Quick Ratio here is 0.87x, which means that ITW has $0.87 of Cash + AR for each $1.00 in current liabilities.

This means that ITW could not afford to repay all its obligations using its Cash + Owed Payments from Customers.

Some people would call that a negative sign, but, again, context is king here.

It’s only negative if the company ever enters such a stressed situation that an immediate repayment becomes necessary; if not, it means nothing.

The bigger issue is that it seems like the company’s liquidity has deteriorated over the past few years:

Liquidity Ratios for Illinois Tool Works

This is concerning because it suggests that ITW’s Cash balance has been falling, while its Short-Term Debt has been rising.

On the other hand, even with these additional numbers, we still don’t have the full context.

For example, many companies raised additional Debt and Equity during the COVID-19 pandemic to boost their Cash reserves.

If Illinois Tool Works did this, its FY 20 numbers may be artificially inflated – and its FY 22 numbers may simply be a “return to normal.”

To determine this, we’d need to go back 10-15 years and also look at the quarterly numbers rather than the simple annual ones.

Quick Ratio vs. Current Ratio

Both the Quick Ratio and Current Ratio are valuable in financial analysis and are used to evaluate a company’s liquidity.

However, there are distinct differences in their calculations and meaning:

1) Scope of Assets Considered: The Quick Ratio focuses narrowly on the most-liquid assets — specifically, Cash, Cash-Equivalents, and Accounts Receivable. It is based on the idea that certain assets, such as Inventory, may not be as easily convertible into Cash, especially in a crisis or downturn.

On the other hand, the Current Ratio includes all current assets, including everything above and Inventory and Prepaid Expenses.

2) Conservatism: Given its exclusion of Inventory and other less-liquid assets, the Quick Ratio is often viewed as the more conservative liquidity measure. This is especially pronounced in industries with slow inventory turnover, such as spirits (alcohol) companies.

3) Lender Perspective: From a creditor’s standpoint, understanding a firm’s immediate liquidity is important. While the Current Ratio provides a broader perspective on short-term solvency, the Quick Ratio tests the company’s ability to meet its obligations without liquidating Inventory or selling other assets.

As a result, lenders may weigh the Quick Ratio more heavily when assessing creditworthiness in certain contexts.