Short Term Liquidity

Quick ratio measures the ability of a business to come up with the cash to pay its debts as they fall due.

Short Term Liquidity

The general definition of liquidity is described as current assets less current liabilities, i.e. net current assets; also known as working capital.

This is measured by "current ratio" - i.e. Current assets divided by current liabilities. Short term liquidity however is measured by quick ratio, also known as the "acid test." These represent a far  more searching definition of liquidity.

Calculating Quick Ratio

The most important current assets include cash, accounts receivable and stock /inventory in that order of precedence. The value of of merchandise on the shelf comes last because that seen as taking the longest time to be turned into cash.

As a result stock / inventory is considered to be the least liquid of the current accounts and so is disregarded when calculating quick ratio. Instead this is arrived at by dividing (current assets less stock / inventory) by current liabilities.

Assessing Quick Ratio

Whereas a current ratio less than 1 spells potential cash flow insolvency, the same cannot be said for quick ratio. It is called the acid test because it usually describes a worst case scenario.

Returns that are considerably below 1 however can be interpreted as a warning sign, even for a going concern which is trading regularly. The reason is that it can mean a business is carrying a higher level of stock / inventory than its liquidity can sustain. This can especially be the case for some seasonal businesses.

For working examples of current and quick ratios, follow the links below. The working example for Figurewizard's monthly budgeted cash flow forecast is also worth a look.

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