How to Perform a Quick Ratio Analysis

A quick ratio is also known as an acid test ratio. It is "a stringent test that indicates whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory." In other words, this analysis is used to weigh the current assets against the current liabilities. This helps the business owners to determine whether the company is financially stable and healthy. This analysis is not to be confused with a working capital ratio-or current ration- which includes the inventory in the analysis.

It is easy to calculate the quick ratio. First the current assets are calculated, excluding the inventory. This includes the cash on hand, accounts receivable and short-term investments that can easily be liquidated into cash. Second the current liabilities are calculated. The liabilities are divided into the assets. That is all there is to it. The formula is: Quick Ratio= (Current Assets-Inventory)/Current Liabilities.

The balance sheet lists both the assets and liabilities. However, not all of these are current. Any asset that is not liquid, something that can not be readily invested into cash is the short run, is considered to be a fixed asset. For example, stocks that are invested for a long period of time, are fixed assets. The same is true for liabilities that are not currently being paid on. For example, a business may have a loan with a lender and may have a plan where the owners do not need to make a payment for several years. This would be a non-current liability. The individuals who do the quick ratio must be knowledgeable about the company's financial statements and know the difference between current and fixed assets, and between current and non-current liabilities.

The ration shows the financial strength of a company. It is desirable to have a quick ration of 1.0 or higher. The company is considered to be financially stable with this ratio, since the liabilities can be covered can by the cash on hand, what is coming through accounts receivable and money coming from short-term investments. However, if the ration falls below 1.0, this is an indicator that the company will not have enough assets to cover the liabilities. Therefore, inventory may need to be sold or lenders need to be contacted for additional funding.

Business operations vary from month-to-month. Therefore, a quick ratio must be calculated at least once a month. For example, on one month a company may have a ratio over 1.0. However, the next month it may fall below the objective. This ratio is a key for managers to pinpoint the issues within the business. By comparing the ratios from a specific month to a month in the past, the business leaders can tell how the company is doing. These ratios are important in key decision-making for the future.

References:

http://www.investopedia.com/terms/a/acidtest.asp