Quick Ratio and company health
Before buying an iPhone, we check it is working fine
Before buying a car, we check it is working fine
Before investing in a company, we MUST also check it is working fine
For example:
Can the company pay-off its short term liabilities?
How much new debt can the company take and still pay off its bills?
To find out, one way is to use the Quick Ratio
What is Quick Ratio?
It measures a company's ability to pay off its current liabilities with its most liquid assets
We calculate Quick Ratio using numbers from the balance sheet
Quick Ratio formula:
Quick Ratio = (Current assets - Inventory - Prepaid expenses) / Current liabilities
or
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / (Accruals + Accounts Payable + Notes Payable)
The Quick Ratio only takes into account the company's most liquid assets. These include cash, accounts receivable, and marketable securities.
Quick Ratio calculation excludes less liquid assets like inventory and prepaid expenses. Why?
Because in the event of a financial crisis, speed to raise cash is key
It may be difficult to sell inventory or prepaid expenses in crisis
What is a good Quick Ratio?
1/ High Quick Ratio (greater than 1.5)
Very good financial strength
Company has enough cash or liquid assets to weather financial storms
2/ Average Quick Ratio (between 1.0 - 1.5)
Considered good financial strength
Suggests that a company has enough liquid assets to pay off its current liabilities
3/ Low Quick Ratio (less than 1.0)
Companies may have difficulty meeting short-term obligations
This could put it at risk of defaulting on its debt
Quick Ratio is especially important for companies with high current liabilities. For example:
- Companies in the retail or manufacturing sectors have high current liabilities
- They may have a higher risk of running out of cash
Company's ability to meet short term obligations is crucial for long term survival.
What are the limitations of Quick Ratio?
Unable to capture a company's ability to convert its non-liquid assets into cash quickly
Unable to differentiate between different types of current liabilities
May depend on the industry in which the company operates
In summary, the Quick Ratio is an important indicator of a company's financial health. It provides insights into a company's ability to cover its short-term liabilities.
By analyzing Quick Ratio, investors and business owners can gauge the health of the company. This is important for its long-term survival.
We should use Quick Ratio along with other metrics to get a better picture of the company's financial health.
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