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Liquidity ratios are working capital assessment tools, used to measure an entity’s ability to fulfill its financial obligations in the short-term. This includes ready cash or instruments that can realize into cash swiftly. These resources must be sufficient to pay off liabilities that are due in the short-term. Two of the most important liquidity ratios are the Current Ratio and Quick Ratio.
Difference Between the Two Metrics
Current ratio is a more popular parameter, calculated as
Current Ratio = Current Assets/Current Liabilities
The time period, in this context, refers to 12 months or less
Quick ratio, on the other hand, is a more stringent measure of liquidity. It omits all elements from the current assets and liabilities that are prone to go illiquid due to the nature of their application in the business. The time period under consideration is 90 days. Most types of industries, not all, have operating cycles typically ranging between 60-90 days. Therefore, this ratio can be a fairer estimation of short-term solvency for most businesses.
Before going further, read this detailed discussion on the how to judge the liquidity potential of current assets and why it can completely change your financial management. (Read Time: 7 min 15 sec.)
Why Quick Ratio
The standard tools of analysis work on the premise of “one-size-fits-all”. However, it is better to employ an organized, yet flexible approach that speaks to the circumstances of an enterprise more specifically. Quick ratio does just that. Not all businesses will need it, but most will benefit greatly from this additional layer of analysis.
For instance, an industry that depends upon the fast movement of goods, say fresh farm produce, can do away with this KPI (Key Performance Indicator). However, if the products have a longer shelf-life (such as FMCG) the role of inventory becomes important.
Calculating Quick Ratio
Just like other liquidity ratios, Quick Ratio is also a Balance Sheet tool. You begin by scrutinizing the components of current assets and liabilities. If you are analyzing your own company’s financials you know where to look. For others, you might find the disclosure on the face of the Balance Sheet or in the “notes to accounts” section. The mathematical formula is,
Quick Ratio = [Current Assets – Inventories – Prepaid Expenses]/[Current Liabilities – Bank Overdraft]
Though, a more appropriate definition would be,
Quick Ratio = Quick Assets/Quick Liabilities
Variable 1: Quick Assets
Certain components of current assets are excluded to arrive at this value. Each item is tested on the parameter of conversion into cash within 90 days. The following components are excluded from total current assets.
Out of the total cash, deduct ‘restricted cash.’ Such portion is not available for immediate use due to certain statutory or other encumbrances.
The accumulated saleable goods can be liquefied only upon a sale. Therefore, they may not be readily realizable as and when needed.
Advances, Prepaid Expenses, and Deposits
Though prepaid expenses are assets in that they imply some certain future outflows already met, they may or may not be converted into cash, if required. You can include only those deposits that carry a refundability clause that comes into effect in certain conditions.
Variable 2: Quick Liabilities
Accounts receivable/creditors, current portion of long-term debt, income tax payable, and miscellaneous accrued expenses commonly constitute Quick Liabilities. There is a little doubt about the materialization of most of the short-term liabilities and therefore, you will include them. However, some cases may warrant a different approach. A hypothetical example would be a small government loan, which gets converted into a grant. One component of liabilities – borrowing against a credit line – is not a straightforward debt. The following explains why that is.
You can draw bank overdrafts against the credit lines that usually extend for periods beyond a year. Under the standard term, you can renew them on expiry. More or less, these instruments often tend to become a more permanent source of financing. While the textbook definition so states, more often than not bank overdrafts are not callable on demand. This adds another degree of permanence.
Why Super-Quick Ratio
Super-Quick Ratio = (Cash & Cash Equivalents + Marketable Securities)/Quick Liabilities
Marketable securities, in this case, require a closer scrutiny. Learn all about the different classes current assets. This ratio indicates that portion of short-term liabilities that can be covered by ready cash and sale of investments. It can particularly be useful for businesses where creditor turnover is higher than the debtor turnover. This implies that payments to suppliers fall due quicker than money received from buyers. It certainly does not imply that businesses must keep large cash reserves just to meet this parameter. This will vary from case to case. If you want to manage your resources, such that they boost your bottom line, send us a WhatsApp message at +919654421064. Eurion Consulting works with companies operating in the U.S., Europe, and India. We cater to business from other parts of the world on a case-to-case basis.
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