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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.
What Is Quick Ratio?
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.
How Do You Calculate Your Quick Ratio?
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
Or
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.
What Is a Good Quick Ratio?
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:
- The type of industry you are in, and what the average length of your billing and payment cycles are – if you usually get paid on order or delivery, a lower Quick Ratio might not matter, but if you have to wait 60 or 90 days to get paid, that could be dangerous
- How well you can collect those outstanding payments – if you regularly struggle to collect from customers, you will want to have a higher Quick Ratio to offset the risk
- Growth is another factor – often, companies that are growing very quickly might have a lower Quick Ratio, because they keep increasing their sales volumes, but as long as they have the capacity to deliver, that’s not necessarily a problem
- Risk appetite is another factor – some company owners are okay with having more debt and less money in the bank – it’s a fine line and leaves less margin for error, but it might work for some businesses
- What kind of inventory you have, and how quickly you can sell it – if you carry a lot of inventory, you need to be sure you can cell it quickly at full price or near full price if you need to access the money that is held there
- The economy in general – as a rule of thumb, the more stable the economy is, the lower your Quick Ratio can be, but if things are rocky, you’ll want to convert more of your assets into easy to access cash and assets
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.
What Does a Quick Ratio of 1.5 Mean?
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.
How to Increase Your Quick Ratio
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.
How Often Should You Calculate Your Quick 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.
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