Quick Ratio or Acid Test Ratio
Current Ratio measures the company’s ability to realize its current assets for satisfying current liabilities as fall
due. However current assets include “Stock in Trade” which cannot be realized as quickly as other current assets (least liquid in current assets). The ability to satisfy current debts therefore should be calculated excluding the inventory .This ratio is called Quick Ratio or Acid Test Ratio.
FORMULA
Quick or Acid Test Ratio = |
Current Assets-stock Current Liabilites |
EXAMPLE
Quick Ratio is calculated by dividing Current Assets, after excluding stock in trade (inventory) and stores and spares, with Current Liabilities of the company as appearing in financial statements (statement of financial position).
Quick or Acid Test Ratio =
2,152,920-620,838-68,982
791,840
Quick or Acid Test Ratio =
1.848 times
Data used in calculating ratio is extracted from Hypothetical Financial Statements. (See Hypothetical Financial Statements used in calculation).
MEASUREMENT UNIT
Quick ratio like current ratio can either be measured in times or in currency units (dollars).
Using the above example the company has 1.848 times current assets (excluding inventory) to satisfy its current liabilities or the company has 1.848 dollars in current assets (excluding inventory) for each 1 dollar current liability.
INTERPRETATION
How to interpret the ratio
As discussed above current ratio is not accurate measure to calculate the short term solvency of the company since current assets include inventory which is not realized as quickly as other assets. Also other risks are associated with inventory e.g. inventory might include damaged goods which perhaps never be sold out or inventory might include obsolete goods thus rendering the inventory slow moving.
Due to risks associated with inventory it will be more appropriate to exclude inventory while calculating the ratio since users are interested securing their debts as discussed in current ratio. Thus Quick Ratio or Acid Test Ratio is used.
The ratio indicates how many times current assets (after excluding least liquid current asset i.e. inventory) of the company will be sufficient to pay the current liabilities of the company. For settling current liabilities (which are obligations of the company to be settled within following 12 months) the current assets are prime source since these will also be realized within 12 following months and in current assets inventory is excluded which takes the most longer period in realizing into cash.
Therefore if Quick ratio is 1, the company has sufficient coverage for its current liabilities.
If Ratio is greater than 1 (> 1) the company has more current assets than its current liabilities for settlement thus good liquidity. However higher ratio does not always is satisfied e.g. current assets might include debtors which might realized after 6 months or more.
If Ratio is less than 1 (< 1) the company has fewer current assets than its current liabilities for settlement thus unsatisfied liquidity. It means if all the current liabilities fall due at once company has to use its long term assets for satisfying the current liabilities.
Users’ needs addressed by the ratio
Creditors are most common users of short term solvency ratios as they are making transactions with the company on short term credit (10 days to 3 months). Creditors are interested to check that company’s current liabilities have sufficient cover of its current assets to meet the obligations as fall due.
If Quick ratio is below 1, creditors might not deal with the company on credit or perhaps terms of credit might be extremely rigid. Moreover they will check other non financial information before extending the credit facility to company.
Management is another user of quick ratio. This is linked with the creditors since management wishes to have creditworthiness for its creditors in order to run its business smoothly. Therefore management critically monitors the quick ratio.
(You might want the understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).