June 16, 2022
It’s often said that it’s cash flow and not profits that really determine a company’s success and failure. There are many companies that simply run out of money even though their order book is full, and they have lots of invoices to collect on.
This is why it’s always important to know how much money you have available that you can access quickly. The Quick Ratio, Liquidity Ratio or Acid Test is the way to do this.
The Quick Ratio is a number that is calculated by dividing your liquid assets in cash, accounts receivable and some kinds of bonds by your current liabilities.
In the accounting world, liquidity means money that you can access quickly, which is how this ratio got its name.
There are two accepted formulas for calculating your Quick Ratio, and while they are slightly different, they do the same thing.
The Quick Ratio formula is:
Quick Ratio = (Current Assets - Inventories - Prepaid Expenses) / Current Liabilities
Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
All of these figures should be easy to access from your accounting software such as QuickBooks, and if you use LiveFlow, you can create a Google Sheet that automatically syncs, and updates your formula based on your Balance Sheet. This way, you will always be able to see exactly where you stand.
Generally, the amounts that are considered assets when you are calculating your Quick Ratio is any money that you can access in 90 days or less. So fixed deposits, property that you own and other types of assets are not included in the calculation.
When you calculate your Quick Ratio, the number you are left with at the end of the calculation is an indication of how many cents you have to service every dollar of liabilities you have.
So, for instance, if your quick ratio is 0.95, that means you only have 95c available for every dollar that you owe. That’s not the worst thing that can happen to you, but it does mean that if everything you owe were to become due on the same day, you would not be able to pay everything.
There are several things that determine whether a quick ratio is good or bad though, including:
It’s also worth noting that when you’re asking what is a good Quick Ratio, there’s the issue of having a ratio that is too high.
If you have too much money in cash and other very liquid assets, you might not be using your money effectively to grow your business. This is fine if you don’t want to grow your business any more, but if you are looking for new ways to expand, you might want to find ways to invest more money back into your business to increase capacity and sales.
A Quick Ratio of 1.5 means that you have $1.50 in liquid assets for every $1.00 that you owe. This means that even if every debt were to be due on the same day, you would be able to pay them and still have money left over.
Anything over 1 is usually considered a safe Quick Ratio, because it’s very unlikely that you will ever be in a situation where everything is due on the same day, so it’s a sign that you can service all your debts and obligations without any trouble.
There are several reasons why your Quick Ratio might change over time. One common reason is that you’ve taken on a large order that required you to purchase more materials or spend more on production.
If your Quick Ratio is lower than you are comfortable with, the best way to change it is to invest more of your profits in cash and other easy to access assets. This will increase your assets and increase your ratio.
You could also sell or cash in other investments, like property, and put that money into cash accounts. While you might not want to sell those assets, it is a good way to unlock their cash value and improve your ratio.
Ideally, you should be able to access key financial information like your Quick Ratio whenever you choose to. It’s a very useful tool to take the temperature of your company, see how you are doing and make informed decisions, without reading complex financial reports.
If you have an accountant or financial professional on your team, they will know how to calculate Quick Ratios, and if you’re using accounting software to track your business’s financial affairs, they should have access to the information they need to do the calculation any time they choose to.
However, since most accountings and CFOs are busy people, they might also want to use a tool like LiveFlow to automate this calculation. Then you can access it whenever you need to, and they don’t have to reinvent the wheel every time you need to.