What is a company’s Quick Ratio?
The Quick Ratio is a way to evaluate a company’s financial health by determining if it has enough cash or other current assets to cover its current liabilities. Effectively the Quick Ratio determines if a company can afford to pay its bills due within the next year without having to sell off inventory or other assets.
The Quick Ratio is a more conservative evaluation metric than the current ratio, which takes into account all current assets including inventory. Quick Ratio does not factor in inventories, or other assets which could not potentially be converted into cash quickly.
The numbers needed to determine a company’s Quick ratio are found on the company’s most recent balance sheet statement, located within a 10-q or 10-k report, which can be found on the SEC’s website found here.
Example below from Intel’s (INTC) 2012 2nd quarter earnings. (Click to enlarge)
The formula for Quick Ratio is:
It is also worth noting, that many would not include deferred tax assets in the calculation for quick ratio, in addition to inventories. The Quick ratio should not factor in any type of deferred asset on the balance sheet. Other terms you may see on a company’s balance sheet that should be excluded from the Quick Ratio calculation are; restricted cash, prepaid expenses and deferred income taxes.
So from Intel’s balance sheet shown above, we will use Cash and Cash Equivalents, short term investments, trading assets, accounts receivable and other current assets to calculate Intel’s Quick Ratio:
This gives us a Quick Ratio of about 1.83 for Intel, a very high number. This tells investors that Intel has more than enough money to cover its current liabilities.
A value of 1.0 would indicate that a company could just barely pay current liabilities with its most liquid assets. A 1.0 value means current assets minus inventory and other deferred assets equal current liabilities.
The higher the value, the healthier the company’s short term finances are. Even in the event of a slowdown of sales (or $0 in sales as the quick ratio assumes), Intel would be able to pay its bills due within the next year.
To compare the Quick Ratio to the current ratio, notice Intel’s current ratio for the same quarter is 6.8 (see the current ratio page here to see how that is calculated). This shows how excluding inventories and other more restricted current assets can change the appearance of a company’s short term finances. Before weighing the results from one ratio over another, be sure to consider what assets are included or excluded in each ratio. The quick ratio assumes no inventories will be sold, an unlikely scenario under any economy. However the current ratio is too inclusive, factoring in assets which may not be able to be quickly converted into assets.
Personally, I consider the quick ratio a “safer” evaluation metric due to its more conservative nature.
It should be noted as well, that this is merely one evaluation metric. A company with a higher quick ratio than another may not necessarily be a better investment. In fact, if a company has too high of a quick ratio, it may not be investing enough money into company growth because it is only hoarding cash. A value of 1 or greater is desirable, but a value significantly higher may not be because the company is not fueling potential future growth as much as it could be.
And further, a declining quick ratio may be a sign of significant investment of a company’s cash and a catalyst for future growth and future stock price growth. And lastly, a quick ratio less than 1 is, by itself, not a surefire bet that the company is struggling to pay its bills. Companies with high inventory turnover in combination with keeping low cash on hand, such as Coca-Cola, may have very low quick ratios (Coca Cola’s is currently around 0.4 as a write this). Obviously, Coca-Cola is not going under next year. When using the quick ratio (or any other indicator), it is important to use the result in context with all the data on the company’s financial statements.
The quick ratio is just one of many evaluation tools for investors and should not be the sole basis for an investment.
Interpretation of Financial Statements, Defines this as:
“The ratio of current assets excluding inventory to current liabilities may be called the “quick ratio”. The current ratio should be generally analyzed further by separating out the inventory. It is customary to require that the cash items and the receivables together exceed all current liabilities.”
Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports, Defines this as:
“Quick ratio is an even more conservative measure of liquidity than the current ratio. It is sometimes called the acid test. The quick ratio is the company’s cash and accounts receivable divided by current liabilities. Inventories are left out.”
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