The quick ratio, defined also as the acid test ratio, reveals a company’s ability to meet short-term operating needs by using its liquid assets. It is similar to the current ratio, but is considered a more reliable indicator of a company’s short-term financial strength. The difference between these two is that the quick ratio subtracts inventory from current assets and compares the quick asset to the current liabilities. Similar to the current ratio, value for the quick ratio analysis varies widely by company and industry. In theory, the higher the ratio is, then the better the position of the company is; however, a better benchmark is to compare the ratio with the industry average.
Quick ratios are often explained as measures of a company’s ability to pay their current debt liabilities without relying on the sale of inventory. Compared with the current ratio, the quick ratio is more conservative because it does not include inventories which can sometimes be difficult to liquidate. For lenders, the quick ratio is very helpful because it reveals a company’s ability to pay off under the worst possible condition.
Although the quick ratio gives investors a better picture of a company’s ability to meet current obligations the current ratio, investors should be aware that the quick ratio does not apply to the handful of companies where inventory is almost immediately convertible into cash (such as retail stores and fast food restaurants).
The current ratio formula is as follows:
Current ratio = (Current assets – Inventories) / Current liabilities
Or = Quick assets / Current liabilities
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