Quick ratio is in fact a strict calculation of an entity’s ability to settle its short-term liabilities. This ratio is widely accepted as the best test available for measuring the entity’s liquidity position. This ratio is also called ‘acid test ratio and ‘liquid ratio’. The formula of this ratio (explained herein under) consist of most liquid assets available to service short term obligations/liabilities.
Since the current ratio include inventories (stocks) which may not be realized in cash quickly as compared to other current assets, so another parameter measuring short term liquidity of the entity is developed. This measure is ‘quick ratio’ which leaves the inventories out of calculation while measuring short-term liquidity. Quick ratio is considered superior to current ratio because it expresses the liquidity position of the entity in a more specific way. Generally, quick ratio of 1:1 is considered satisfactory which denotes that the entity will meet its current obligations easily when they become due.
Quick ratio is computed by taking all current asset other than inventories and prepayments divided by all current liabilities. The formula can be expressed in the following way:
The following are the extracts of financial statements of M/s UNISA Pharmaceuticals (Pvt) Limited for the year ended December 31, 2016.
Advances & prepayments $ 12,000
Stocks in trade $ 20,000
Trade receivables $ 15,000
Marketable securities $ 5,000
Cash & bank balances $ 30,000
Total current assets $ 82,000
Trade payables $ 10,000
Current portion of long term liabilities $ 17,500
Accrued & other liabilities $ 15,000
Total current liabilities $ 42, 500
we can compute quick ratio by putting values in the formula i.e. current assets – inventories – prepayments / current liabilities
82,000 – 20,000 – 12,000 / 42,500
1.18 OR 1.18 : 1
Prepayments and inventories are excluded from current assets. This is so done due to following reasons:
- Prepayments are not realized in cash but the same are usually subject to certain adjustments in future. Since generation of cash cannot be expected from prepayments, therefore, these are not considered while computing quick ratio.
- Inventories are also left out of calculation because these take more time to be realized in cash as compared to other current assets. This is because of several facts associated with the inventories such as inclusion of slow moving stocks, existing of obsolete stocks, slow production process etc. Therefore, in computation of Quick Ratio, inventories are not included into current assets.
- An entity may own a healthy standing with respect to current ratio enjoying standard position i.e. 2:1 but it is quite possible that the same entity may have quick ratio below the standard/norm that is 1:1. In such situation interpretation can be placed that a major part of entity’s current assets has been tied up in slow moving and unsaleable inventories. In other words, a satisfactory current ratio with a low acid test ratio shall be an indication of existence of high level of inventories. This warrants afresh analysis of the matter and review because in such situation the management may face difficulties in paying its current obligations.
- Quick ratio is one sort of check over the liquidity position of the entity as established by the current ratio.
- Though it has been regarded as a more rigorous and probing measure of entity’s liquidity position, yet this cannot be considered as a conclusive check/test.
While forming an opinion regarding the short-term liquidity status of the entity, the both current ratio and quick ratio should necessarily be measured in relation to the industry averages.