Ratios: Quick (Acid Test) Ratio - Online Tutor, Practice Problems & Exam Prep

The quick ratio, also known as the acid-test ratio, measures a company's ability to cover its current liabilities with its most liquid assets. It is calculated using the formula: Cash + Short-term Investments + Net Accounts ReceivableCurrent Liabilities. A quick ratio below 1 indicates potential liquidity issues, as it shows insufficient liquid assets to meet short-term obligations. This ratio excludes inventory and prepaid expenses, focusing solely on assets that can be quickly converted to cash.

Ratios: Quick (Acid Test) Ratio

Now let's discuss another ratio called the quick ratio. This is similar to the current ratio, but it's a little more strict. Let's check it out. The quick ratio is sometimes called the acid test ratio and this isn't the 1970s, this isn't turn on, on, tune in, drop out. No, we're studying accounting here, it can't get any more bland. So let's check it out. We've got the quick ratio, it's going to be similar to the current ratio which you've probably studied and remember the current ratio we're talking about current assets, current liabilities, being able to cover those liabilities in the short run. Well, the quick ratio is similar. It is another liquidity ratio, but it's only going to use the most liquid assets in the numerator rather than all of our current assets, we're only going to talk about the most liquid ones. Okay? So let's check out the quick ratio here and notice in our numerator, we no longer have current assets like we did when we studied the current ratio. Instead, we have a small portion of our current assets. We've got cash which is very liquid. Short term investments, those are also very liquid. That could be just shares of stock that you own. Anything that has some marketable value just like if you own a share of Apple stock, right? You could look up the stock price and you could sell that stock right away at a stock price. So that's very liquid. And net accounts receivable, those are generally pretty liquid as well. We're going to be getting the money from our customers pretty soon and even in case we needed the money quicker, we can generally sell our accounts receivable to other companies and get a portion of them now. So they're very liquid as well, okay? So one way that we can calculate the quick ratio is in our numerator to have those. The cash, short term investments, and the net accounts receivable. Right? We could have those in our numerator and then our denominator is the same as the current ratio. It's just all of our current liabilities, right? So we're still want to check, can we cover our current liabilities, but we want to see if we can cover them with these quick assets. These very, very liquid assets. Okay? So another way we can think about the quick ratio is to do it the other way where we take all of our current assets. Notice in this case, we start with all the current assets and this is to calculate the same thing, but except now we're taking all our current assets and we're going to take stuff out that's not super liquid. So our inventory, we take out of our current assets and our prepaid expenses, which are just not as liquid as the ones we described above, right? So in essence, we get to the same thing because those are the 5 most common current assets. Cash, short term investments, accounts receivable, inventory and prepaid expenses. So we're taking out the less liquid ones and leaving only those very, very quick ones. Okay? So how do we analyze this ratio? Well, it's very similar to how we analyze a current ratio. The quick ratio, well, it tells us how many highly liquid assets, so how many dollars of these highly liquid assets we have for each dollar of current liabilities, right? So again, this has a similar red flag again to the current ratio. Very, very similar in analysis. The quick ratio, if we have it below 1, right? If we have a quick ratio below 1, it can be signs of liquidity problems again, right? Because we're talking about being able to cover our current liabilities in the short term and if we're not able to do that, well, we've got liquidity problems. But remember, this is a little more strict, right? We're not talking about all of our current assets. We've been a little more strict than thecurrentratio. So a low currentratio is even more of a red flag than a low quick ratio because when we have inventory prepaid expenses in there, well, that can help us cover our current liabilities in one way or another. Alright? So let's go ahead and do an example and let's use our quick ratio to solve this problem right here. So we've got right here super liquid company, has current assets totaling $ 450,000 and current liabilities totaling 315,000. Included in current assets are 115,000 of inventory, 35,000 of accounts receivable, and 10,000 of prepaid expenses. Current liabilities include 120,000 in short term debt, calculate the quick ratio for SLC. So this is something they love to do in accounting problems and especially in ratio problems

The following table contains selected financial information for Tougher Question, Inc.

Calculate the quick ratio for TQ, Inc.

Alright. So I'm guessing you guys tried the practice problem. Let's dive right in. So the following table contains selected information for Tougher Questions, Inc. Alright? They're asking us to calculate the quick ratio again, but they gave us the information in a different way, right? They listed out a bunch of accounts. We have to figure out which ones are our current, well, our quick assets, right? Not all of our current assets. Our quick assets that will be in our numerator and then our denominator will be all of our current liabilities. So let's go ahead and find those. Let's start with our quick assets. Now this isn't a term that's used so often. Quick assets, you might not see that. I'm not sure that it's such a technical term, but it's what we're talking about in the quick ratio. Right? We're talking about those highly liquid assets. So we're looking for cash, our short-term investments, and our accounts receivable. So let's find those real quick. So here's cash, a quick asset. Machinery, no. There's accounts receivable and then short-term debt, land. I don't see anything about short-term investments there. So since they're not listed, well, then we don't have any short-term investments, and then we're done with our quick assets. We see that we've got $45,000 in cash and $10,000 in accounts receivable. So our quick assets total $55,000. Cool. Easy enough. Now let's find all of our current liabilities. So remember, that's going to be our denominator here where the quick assets are our numerator. Liabilities. It's hard to talk and write at the same time. So let's find all of those current liabilities that are going to be in our denominator. Alright? So what do we got? Machinery, that's an asset. Right? Short-term debt. Is that a current liability? It is, right? Short-term debt, that's short term. So it's debt is a liability, something we're going to have to pay out and we're paying it out in the short term. So it's a current liability. Land, that's an asset, right? So it's not a liability and it's a long-term asset. Accrued expenses, those are current liabilities, right? These are accruals that we made maybe through adjusting entries, some expenses that we've received the benefit, but haven't paid them out yet. So that's a current liability. We're going to have to pay that out soon. Inventory, that's a current asset, right? It is a current asset, but it wasn't a quick asset. So that's why it doesn't get used here. How about accounts payable? That is a current liability, right? That's one of our most common current liabilities that we always see. Common stock, note that's equity, bonds payable. Now bonds payable, these could be current liabilities, but they would have to specifically let us know that they're due soon. Because in general, bonds payable is some sort of long-term liability where we sold some bonds, we got money for it, and we're going to have to pay it back usually in 10 years, 20 years. It's usually some long period of time. But sometimes that time period is coming up. Maybe we did it 20 years ago and that time is coming around the corner. They could be current, right? But they would have to tell us specifically in the problem. So those are long-term. Prepaid expenses, again, those are current assets, but they are not those quick assets we're looking for and then retained earnings, so that's an equity account as well. So that's good. We found all of our current liabilities. Let's add them up. $40,000 in short-term debt, $35,000 in accrued expenses, and $30,000 in our accounts payable. So let's add all of those up and we get $105,000. Right? We've got $105,000 in current liabilities. So all that's left is to calculate our quick ratio. Let's do that over here. Quick ratio, Remember, it's our quick assets that we calculated as $55,000 divided by our current liabilities, $105,000 right there. Okay. So let's do it. $55 divided by $105. Wow, we got a pretty little quick ratio here, right? 0.52. Alright? So this is probably showing that this company might have some difficulty paying off its current liabilities, Right? When we think about the current ratio, what we'd be adding in that inventory, those prepaid expenses, but that's not as liquid as what we dealt with here. So since we've got this stricter amount of assets that we've put as the highly liquid ones, well, we ended up with a pretty low quick ratio here. So this could be a red flag that they're going to have some liquidity problems in the future. Alright? Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the quick ratio and how is it calculated?

The quick ratio, also known as the acid-test ratio, measures a company's ability to cover its current liabilities with its most liquid assets. It is calculated using the formula:

$\frac{\mathrm{Cash}+\mathrm{Short}-\mathrm{term}\mathrm{Investments}+\mathrm{Net}\mathrm{Accounts}\mathrm{Receivable}}{\mathrm{Current}\mathrm{Liabilities}}$

This ratio excludes inventory and prepaid expenses, focusing solely on assets that can be quickly converted to cash. A quick ratio below 1 indicates potential liquidity issues, as it shows insufficient liquid assets to meet short-term obligations.

Why is the quick ratio considered more stringent than the current ratio?

The quick ratio is considered more stringent than the current ratio because it only includes the most liquid assets in its calculation, such as cash, short-term investments, and net accounts receivable. Unlike the current ratio, it excludes inventory and prepaid expenses, which are not as easily converted to cash. This stricter approach provides a clearer picture of a company's ability to meet its short-term liabilities without relying on the sale of inventory or the realization of prepaid expenses.

What does a quick ratio below 1 indicate?

A quick ratio below 1 indicates potential liquidity issues for a company. It means that the company does not have enough liquid assets to cover its current liabilities. This can be a red flag for investors and creditors, as it suggests that the company may struggle to meet its short-term obligations, potentially leading to financial difficulties.

How do you calculate the quick ratio if only partial information is given?

If only partial information is given, you can calculate the quick ratio by starting with the total current assets and subtracting the less liquid assets, such as inventory and prepaid expenses. For example, if you know the total current assets, inventory, and prepaid expenses, you can use the formula:

$\frac{\mathrm{Total}\mathrm{Current}\mathrm{Assets}-\mathrm{Inventory}-\mathrm{Prepaid}\mathrm{Expenses}}{\mathrm{Current}\mathrm{Liabilities}}$

This will give you the quick ratio, focusing on the most liquid assets available to cover current liabilities.

What are the components of the quick ratio?

The components of the quick ratio include the most liquid assets, which are:

• Cash
• Short-term investments
• Net accounts receivable

These assets are included in the numerator of the quick ratio formula. The denominator consists of the company's current liabilities. The quick ratio formula is:

$\frac{\mathrm{Cash}+\mathrm{Short}-\mathrm{term}\mathrm{Investments}+\mathrm{Net}\mathrm{Accounts}\mathrm{Receivable}}{\mathrm{Current}\mathrm{Liabilities}}$