The quick ratio, also known as acid test ratio, is used to measure a company’s ability to pay off its current liabilities when these come due – but only with the company’s quick assets.
The quick assets are those assets that are being owned by a company and which can be converted into cash in a short-term or within 90 days. Quick assets can come in the form of short-term investments, cash, marketable securities, cash equivalents, or current accounts receivable.
Marketable securities can be traded on an open market and have a known price, as well as available buyers.
The quick ratio is also known as the acid test ratio because it makes a reference to the way metals were tested for gold by miners in the past – by using acid. A metal passing the acid test meant that it was pure gold, but if the metal was corroded, it was just a base metal – making it worthless.
The Basics of Quick Ratio – Acid Test
The historical acid test can be applied to today’s companies as well. A company must be able to show its worth in a short time, when faced with outside pressure. These types of assets can prove the worth of a company– distinguishing the company as worth it’s true value, like the gold, rather than a corroded base metal.
So, a business must have enough quick assets – pure gold – in order to be able to pay off all of its current liabilities when they come due. If a company is able to do so, it won’t be forced to rely on capital or long-term assets, which are quite vital to a business.
Why are those vital? That is because working capital or long-term assets are the things that a company uses to generate profit and revenue. Therefore, if a company was forced to sell any of those, it would generate less profit or marginal revenue demonstrating to investors that the company is not profitable enough.
Calculating the Formula for the Quick Ratio – Acid Test
The quick ratio can be calculated by using two different equations, both fairly simple. In the first equation case, we start by adding cash ratio, cash equivalents, short-term investments, and current receivables, after which we divide the final result by the current liabilities that a certain company has to pay.
But since some companies don’t show the aforementioned variables separately on their balance sheet, there’s a second formula that can help us come up with the quick ratio.
We start by subtracting any prepaid expenses and inventory from the total current assets of a company, after which we divide those by the current liabilities.
If a company has a quick ratio of 1, it means that its quick assets are equal to its current assets. A high quick ratio is good news because it means that a company has plenty of quick assets it can use to pay off its current liabilities. This means that no long-term assets have to be sold in order to pay off the current liabilities. A quick ratio of 2 means that the company can use its quick assets to pay two times the value of its current liabilities indicating that the company is highly liquid and also profitable. Also using the best business goal tracking software like OKRs can help you fasten your calculations and task management. The conversion and the metrics can be managed with highly qualified key results and objectives that help you move towards your target with measurable results.