Quick ratio or acid test ratio

Define, explain and interpret quick ratio.

Quick ratio (also known as “acid test ratio” and “liquid ratio”) is used to test the ability of a business to pay its short-term debts. It measures the relationship between liquid assets and current liabilities. Liquid assets are equal to total current assets minus inventories and prepaid expenses.

Formula

The formula for the calculation of quick ratio is given below:

quick-ratio-or-acid-test-ratio-img1

Example 1

The following are the current assets and current liabilities of PQR Limited:

Current assets:

  • Cash: $2,400
  • Accounts receivable: $12,000
  • Inventory: $16,000
  • Prepaid expenses: $600

Current liabilities:

  • Accounts payable: $11,600
  • Accrued parables: $1,800
  • Notes payable: $600

Calculate quick ratio of PQR Limited.

Solution

= 14,400*/14,000**

= 1.03

(rounded to two decimal places)

*Liquid assets:

= (Total current assets) – (Inventories + Prepaid expenses)

=$31,000 – ($16,000 + $600)

= $31,000 – $16,600

= $14,400

** Current liabilities:

= $11,600 + $1,800 + $600

= $14,000

Significance and Interpretation

Quick ratio is considered a more reliable test of short-term solvency than current ratio because it shows the ability of the business to pay short term debts immediately.

Inventories and prepaid expenses are excluded from current assets for the purpose of computing quick ratio because inventories may take long period of time to be converted into cash and prepaid expenses cannot be used to pay current liabilities.

Generally, a quick ratio of 1:1 is considered satisfactory. Like current ratio, this ratio should also be interpreted carefully. Having a quick ratio of 1:1 or higher does not mean that the company has a strong liquidity position because a company may have high quick ratio but slow paying debtors. On the other hand, a company with low quick ratio may have fast moving inventories. The analyst, therefore, must have a hard look on the nature of individual assets.

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12 Thoughts on Quick ratio or acid test ratio

  1. ali raza gcuf

    If quick ratio is very high, it means company has high % of liquid assets that shows company is not using their assets properly because company have their asset motionless.

  2. liaqat said

    Too much good explanation with best example and easy to understand
    so do further for the betterment of people our prayers will be with you.

  3. Accounting for Management

    Thanks Liaqat. I need your prayers.

  4. shifa

    In this solution quick ratio is 1.03..
    so, can we write it as 1:03?????

  5. Accounting For Management

    Shifa, you can write it as 1.03:1, not 1:03.

    = 14,400 : 14,000
    = 1.03 : 1

  6. saloni

    Thanks a lot sir………………….

  7. Gaurav Chhibba

    This is the best explanation or interpretation of ratio that i have seen,each and every ratio is very practical and show real time scenario of market /company /industry, thanks and please keep it up.

  8. Ahana Pradhan

    if my quick ratio is 5.86:1, then what is the firm’s position

  9. Kunjal Sheth

    If loans and advances are together ,am I suppose to take it in liquid assets.

  10. aisha noor

    This is a good explanation but I want to know the perspectives of different stakeholders in ratio e.g if quick ratio is increased then how it effects on customers and owners etc. and also industry to industry it varies so I want that information that if their is some service of manufacturing industry then decreased or increased trends will effect them or not.

  11. gaurav jain

    what is formula of acid-test ratio

  12. marshal

    waal great stuff. i wish to get a high mark on my assignment…God bless you

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