Sunday, June 24, 2018

Quick Ratio or Acid Test

          Quick Ratio = Cash & equivalents + Current Accounts & Notes Receivable
                                                            Total Current Liabilities

The quick ratio or “acid test” is a more conservative measure of liquidity than the current ratio.  The numerator includes only the most liquid assets, and it excludes inventory and other accounts such as prepaid expenses.

Some accounting and finance experts simply present the quick ratio numerator as “Current Assets minus Inventory.”  This is the most basic way to calculate the quick ratio.  The quick ratio presented here is actually more conservative, since its assets include only cash, cash equivalents, and accounts and notes receivable due within a year.

A quick ratio below one implies that the business will be dependent upon turning its inventory to service short-term debts.  This may be problematic for a business that is susceptible to seasonal or cyclical fluctuations, a manufacturer with significant unfinished goods, or any business holding obsolete inventory.  If inventory is an issue for a business, then you may study their inventory and accounts receivable turnover ratios to learn more about their ability to turn inventory into cash.

For Smith Heating and Cooling, Inc., their quick ratio is 0.43 versus a current ratio of 1.12.  It appears that the company will, indeed, be dependent upon inventory turnover to service its short-term obligations.  For this reason, it will be important to carefully study the quality of the company’s inventory as well as their turnover ratios to perform a complete financial analysis.

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