In continuation of the fundamental analysis series, we will now take a look at the quick ratio, what it is and how it can be helpful in valuing an investment.
The Quick Ratio is very similar to the Current Ratio in that it measures a company’s ability to cover its liabilities with its working capital.
However, it differs from the current ratio in one important respect: it focuses only on those assets that are considered to be highly liquid, while the current ratio includes all assets, whether liquid or not.
Therefore, the term “fast” refers to the liquidity of the assets rather than the speed with which the calculation can be made.
For this reason, the Quick Ratio is sometimes referred to as the Acid Test Ratio.
The quick ratio is more conservative than the current ratio as it excludes certain assets that could otherwise inflate the ratio.
It is calculated as follows:
“Fast” assets, in turn, are highly liquid assets. There are two main methods of calculating quick assets:
Note that while prepayments are an asset, they cannot be liquidated to meet short-term liabilities; Therefore, they are excluded from Quick Assets.
Even when using the second formula, receivables are only considered an asset if their maturity is 90 days or less.
In accounts receivable, the faster the terms of payment, the better the company’s liquidity position.
It can be helpful to look at not only the accounts receivable terms, but also the accounts payable terms and conditions.
If a company has to pay its suppliers longer than its customers, it can be viewed in a healthy liquidity position as long as the receivables are greater than or equal to the liabilities.
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A quick ratio of 1 is considered normal.
This means that a company has enough assets that can be liquidated immediately / quickly to meet its short-term liabilities.
The key is that the asset being liquidated can be done in the open market with minimal impact on its price.
A company’s inventory includes not only the finished product, but also all raw materials and components.
While in most cases it is possible to quickly liquidate inventory, it is often necessary that inventory be heavily discounted to do so.
It is for this reason that inventory is most often excluded from the quick ratio.
Key figures of less than 1 indicate that an otherwise healthy company can also get into a liquidity crisis.
This was the case in the 2007-2009 global credit crunch.
Many companies have not been able to finance themselves in the short term and fail to meet their immediate liabilities.
In such cases, companies must attempt to liquidate assets through an emergency sale and / or seek bankruptcy protection.
The quick ratio is a more conservative measure of a company’s ability to meet its short-term debt.
While not an immediate crisis, a ratio less than 1 indicates the potential for a problem when short-term finance is unavailable or difficult to obtain.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.