Advantages and Disadvantages of Quick Ratio
Quick Ratio is the financial tool which use to access the company’s short-term financial liquidity position. It measures the company’s ability to use near cash assets to pay off the current liabilities. It is also known as the acid test ratio.
Similar to current ratio, this ratio base on the company’s current assets over the current liabilities. However, it excludes the inventory and prepaid expense as these items may take longer time to convert to cash.
Quick ratio is one of the most popular tools that investors want to access the company’s ability in paying the short-term liabilities without selling off their inventory.
Quick Ratio Formula
| \[Quick\ Ratio = {(Current\ Assets – Inventory – Prepaid\ Expense) \over Current\ Liabilities}\] |
Advantages of Quick Ratio
- Easy to Calculate and Aanalyze: It is very easy and simple to calculate this ratio as long as the company has prepared the financial statements. After getting the result, it is also easy to evaluate, the higher is the better. It means company has enough ability to pay off the short-term debt.
- Exclude Inventory: Inventory may need more time to sell and collect cash, so it is very good to exclude it from this ratio. We want to see the actual assets which can be converted to cash and use to pay off the debt. Moreover, the value of inventory may be decreased over time due to damage, obsolescence, thief, outdate and so on.
- Exclude Bank Overdraft & Cash Credit: it makes the ratio more reasonable by removing the overdraft and cash credit.
- Better than Current Ratio: It is more reasonable than current ratio as it excludes the inventory and other current assets that hard to convert to cash such as prepaid expense.
- Reflect with Seasonal Business: The ratio also responds to the seasonal business as the inventory has been excluded.
Disadvantage of Quick Ratio
- Not enough to make a conclusion: Even this ratio is good, but is not enough to make a conclusion regarding company financial health. The ratio may be low, but it does not mean that company going to liquidate. They may have other sources of funds to support their operation.
- Hard to compare: Comparing the ratio across different industries will not make any sense. Some business requires a huge level of current asset while the other not. So comparing the ratio will not tell us anything.
- Exclude inventory may not suitable for some businesses: The inventory will be converted to cash very fast and easily for the retail store and supper market. So by excluding them from the ratio, it will not show the full picture for such companies.
- Not provide anything related to company cash flow: This ratio is accessing the company abilities to generate cash to pay for current liability, but it is not showing any data related to the cash flow generation.
- Other current assets may be hard to convert to cash: Besides inventory, other current assets may also require a longer time to convert to cash. For example, accounts receivable will be hard to collect during an economic downturn.