by Colaine Swaby

Created on: February 25, 2010

Ratio analysis is conducted for many reasons but mostly they are used to determine a company’s future profitability and to spot unfavourable practices that may have emerged over time. Ratio analysis allows business owners and managers to analyse the growth of their company, determine its future success or failure and clue them in to business trends by comparing their long and short term performance with similar businesses within their industry. In other words they can provide early warning signs that may solve problems before they get out of hand and destroy the company. Financial ratios also help lenders and investors determine a company’s financial risk as well as attractiveness.

Businesses calculate ratios using quantitative data from their financial statements.  Ratios are generally estimated from current year data and then compared with data from previous years, the industry and other companies within the industry as a means to determine how well the company is doing. By themselves financial ratios are useless, but when put into the right context they can give financial analysts a true picture of what’s happening within an organization.  There are many types of financial ratios but they generally fall into two categories; liquidity ratios and profitability ratios.

The quick ratio is a form of liquidity ratio. It is a measure of a company’s short-term liquidity. Sometimes referred to as the “acid test” ratio or “quick asset ratio”, this ratio tells us the ability of an organisation to meet its short term operating needs and responsibilities with its most liquid or “quick” assets. In so doing, it excludes inventory from its calculations because inventory is, in most circumstances, difficult to liquidate. It may be obsolete or, at best, slow moving. Therefore one can easily determine whether or not the business will be sustainable in the short term in the case of a shortfall in sales revenues, where it has to rely on the cash on hand. Will it still be able go meet its debt obligations?

The quick ratio is calculated as follows:    

Quick Ratio = Current Assets- Inventories/Current Liabilities

For example, if your current assets are worth $200,000, your inventories are worth $100,000 and your current liabilities are calculated at $115, 000 then your quick ratio would be .86

(Quick Ratio = $200,000-100000/115000 = .86)

 (quick ratio =.86)

Quick assets comprise current assets that can be rapidly converted into cash at close to their book values. This usually includes cash, accounts receivables and government securities. Current liabilities on the other hand include financial debts that become due within one year such as accounts payable, short-term loans, accumulated expenses, current portion of short term debt, and taxes. A quick ratio of 1:1 is said to be satisfactory. Anything less than 1 and the company would be at risk because it won’t be able to pay its current liabilities. This more often than not indicates that it is highly dependent on inventory to keep it going.

The quick ratio is similar to the current ratio in that the values for the quick ratio fluctuate widely from company to company and industry to industry. In theory, companies with higher quick asset ratios are usually in a better position within the industry than those with lower ratios.  However, a more appropriate yardstick would be to measure this ratio against the industry mean. Passing the “acid test” will auger well for every business and thus should be the goal of every smart entrepreneur.      

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