Quick (Acid Test) Ratio
Hi!
Before this video, you should already understand the words and concepts found in financial
statements.
These financial statements are the Balance Sheet and the Income Statement.
You should have already watched my other free video on Current Ratio.
The topic for this video is Financial Ratio Analysis with a focus on the Quick Ratio which
is one of the Liquidity Ratios.
Remember you can always go back to MBAbullshit.com.
This video discusses and analyzes the Quick Ratio which is one of my free videos on Liquidity,
Profitability and Market Value Ratios which include these ratios over here.
After these, you can check out my next videos on MBAbullshit.com on Financial Leverage Ratios
which include this, which include these and my turnover ratio which include this.
Let’s get down to it.
Let’s start with the story.
Let’s say that ABC company has $1000 in current assets and $800 in current liabilities.
$100 of the current assets is in inventory.
What is the quick ratio?
The quick ratio is very simple $1000 which comes from these current assets minus $100
which is the inventory all over $800 which is the current liabilities.
In the end, we come up with a very simple answer which is this, our quick ratio is 1.125.
Now, as you can see here, it is similar to the current ratio but what’s the benefit
of subtracting inventory over here.
Well, inventory is considered as less liquid.
When we say less liquid, we mean not as easily convertible to cash.
Inventory is considered as less liquid than other current assets.
Why, because it could be lost.
A lot of inventory gets lost in the warehouse or stolen.
It could be outdated meaning you cannot use it anymore so take for example mobile phones
which become obsolete very fast or they could be damaged.
You think your inventory is there in your warehouse and everything is great but you
might not realize that a lot of it is damaged.
That is why we subtract inventory.
Remember, the objective here is to see how much money or assets you have up here, current
assets to pay for your current liabilities found here but subtracting this inventory
over here because it is not easily convertible to cash therefore it cannot easily be used
to pay for these liabilities over here.
So now, we have a figure of 1.125.
What does it mean?
It means that the company has 1.125 times the amount of quick assets to pay for its
current liabilities.
When we say quick assets, we mean assets that can quickly be turned into cash or is already
cash or another way, the company has an excess of 12.5% in quick assets to pay for its current
liabilities.
Where do we get this 12.5%?
It comes from here; this .125 is equal to 12.5 in percentage terms.
This indicates, remember it’s just an indicator; it’s not 100% sure.
This indicates that the company will not have any trouble paying its debt for the next 12
months.
Remember, current assets means easily convertible to cash within the next 12 months.
Current liabilities mean liabilities which need to be paid for in cash within the next
12 months.
So the quick assets are more than the current liabilities for the next 12 months and these
quick assets can be used to pay for these liabilities.
In fact, this company has an excess of 12.5% in quick assets.
So if the quick ratio is high, why is this good?
It is good for creditors such as banks which loan money to the company which need to get
paid back within the next 12 months.
If the quick ratio is high, why is this bad?
It might indicate inefficiency in using short term assets.
Why?
If you are a stock holder or shareholder or an owner, you want ABC company to earn you
profit using as though assets as reasonably possible.
If there are excess assets, you want ABC company to either give it back to you as an owner
because ABC isn’t using it anyway so they might as well give it back to you so that
you can use it personally for yourself or you’ll want ABC to invest in other projects
so that it can earn more profit for the company.
Another thing, this could also signal lack of inventory to reach demand.
Remember, if your current ratio is high maybe because you have a lot of current assets but
not much inventory because remember you have to subtract the inventory to get current ratio.
The reason why you have a high quick ratio is because you did not have much inventory
to subtract.
That is why you ended up with a high quick ratio.
If you did not have much inventory to subtract, it means maybe you don’t have much inventory
so if you don’t have much inventory maybe you lack inventory to reach the demand of
your customers.
That is a bad thing of course because you risk losing your customers who will be unhappy
if you don’t have any inventory to supply them with.
The opposite is also true.
If the quick ratio is low, this could be bad.
It’s bad for creditors definitely such as banks which loan money to the company which
need to get paid back within the next 12 months.
If the quick ratio is low, it could be good.
It might indicate efficiency in using short term assets other than inventory because it
does not include inventory.
If you are a stock holder or shareholder, you want ABC company to earn you profit using
as little assets as reasonably possible.
If you have a low quick ratio, this indicates that maybe you’re not using much assets
but you’re still earning a good amount of profit or you could still be earning a good
amount of profit.
What are the flaws of this ratio?
The first flaw is a high quick ratio may give a false sense of security to creditors by
treating all current assets and liabilities minus inventory equally.
So for example your company has little or zero cash but has quick assets worth $105
which can be converted to cash after 11 months.
Let’s say all your current assets less your inventory equal $105 for example.
But you also have accounts payable in the amount of $23 to be paid next month.
Your quick ratio is very high and ultra healthy 4.57 but next month your company will be toast.
Why, because this $105 can be converted to cash after 11 months.
This is only $23 but it must be paid next month.
You will be toast even if you have a quick ratio of 4.57.
By the way quick ratio is sometimes also known as Acid Test Ratio.
So what is the second flaw?
What is the flaw of this ratio part 2?
A low quick ratio may give a false sense of danger.
Your company has little or zero cash and has quick assets of $105 and accounts payable
of $100, looks like this company has a dangerously low quick ratio of 1.05 and could be in trouble
very soon.
But what if the company has a big line of credit with the banks such as like in the
case of the current ratio?
In which case, they can easily borrow cash to pay for this accounts payable anyway so
they are okay and this company is fine.
This company will not collapse because they can borrow cash.
What if this company has very fast moving inventory anyway?
Remember, in the quick ratio, we subtracted inventory here.
We did not include it because we assume that inventory is not easily convertible to cash
but in some business, inventory is very easily convertible to cash or is very fast moving
so it becomes cash almost instantly.
In this case, even if you have a low quick ratio of 1.05, you will not have a problem
or the company will not have a problem because this inventory will turn to cash very soon
anyway.
An example might be McDonald’s.
I would assume or think that a fast food shop would have inventory which turns into cash
very quickly.
Unlike for example a car shop or a car showroom, if they are not selling any cars then their
cash is stock and frozen within the cars until you can actually sell the car.
But in the fast food joint, the inventory gets sold very fast.
Let’s look at the traditional analysis of this ratio.
First is to compare the historical quick ratios of your company or this company if it is not
your company.
If the quick ratio is higher now than last years’ then either it is a more stable or
less risky debt situation than before or it’s more efficient now than before in managing
assets or both of the above.
If the quick ratio is lower now than last years’ then either it is more risky debt
situation than before or it’s more efficient now than before in managing assets or both
of the above.
The second form of traditional analysis is to compare the quick ratio to that of companies
in a similar industry.
If the quick ratio is higher than similar companies’ then either it’s in a more
stable or less risky debt situation than them or more inefficient than them in managing
assets or both of the above.
When we say inefficient than them in managing assets, it is using so much assets just to
generate cash or just to generate profit.
Remember, from the owner’s point of view, it is better for the company to earn the same
amount of profit but to use a lot less assets, a lot less current assets, a lot less quick
assets or of course both of the above.
If the quick ratio is lower than the similar companies’ then either it is more risky
debt situation than them or more efficient than them in managing assets maybe using less
assets to generate the same amount of profit or both of the above.
So that’s how simple it is.
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Have a great day and goodbye.
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