Explaining How to Calculate the Quick Ratio to Monitor Liquidity
Calculating the Quick Ratio
While it is important in the long term for a business to make profits, another vital issue for every business is that of cash flow and liquidity. Many potentially profitable businesses fail because, they do not have sufficient liquidity to pay their debts as they fall due. The owner or manager of a business must therefore keep a constant watch for signs of liquidity problems, and learning how to calculate quick ratio is one way to do this.
The quick ratio, or liquidity ratio, is arrived at by dividing the current assets, less inventory by the current liabilities. The current assets included in the quick ratio would therefore include accounts receivable (debtors) and cash; and the current liabilities would include trade creditors and accrued expenses.
The quick ratio is a check on how far the business has the cash (or assets that can readily be turned into cash), to ensure that the short term liabilities and needs of the business are met. It is easy to understand how to calculate the quick ratio, and it is difficult for businesses to manipulate this ratio by means of “window dressing” to make the balance sheet look healthier. This means that a business can compare its quick ratio with the ratios of its competitors, to see how secure its liquidity position is by comparison with other enterprises in the same industry.
Why Inventory is Excluded from the Quick Ratio
As the quick ratio is a measure of the company’s liquidity, this accounting ratio looks at the assets available in the short term, to enable the company to meet the current liabilities; in particular to pay the trade creditors. The inventory is excluded from this ratio, because at times it may be very difficult to sell the inventory at short notice, and a company should not rely on its ability to sell its stock quickly to meet the claims of creditors. In some businesses, items of stock may be slow moving, while in other industries (particularly those involving high technology or fashion items), some parts of the inventory may quickly become obsolete. Even in many businesses whose inventory is fast moving, the need to sell off the stock quickly involves offering discounts - a familiar example being retailers clearing old stock in the January sales.
How to Interpret the Quick Ratio
In addition to understanding how to calculate the quick ratio, the business must learn how to interpret the result. If the quick ratio is more than 1.0, this is generally seen as a sign of healthy liquidity, because this shows that the business can pay off its trade creditors with its cash balances and amounts collected from debtors. However a high level of debtors may not necessarily be a good sign for a business. The enterprise may need to examine the amount and age of the debts that are owed to it. The debtors may need to be managed more carefully, by ensuring that debts are collected within the required time period and by reducing the level of potential bad debts as much as possible.
Also, a high level of cash in itself may not be a good sign. Where the business is holding a high level of cash the reasons for this should be examined. It may be that large amounts of cash are lying idle in low-interest deposits instead of being made to work for the business.
The appropriate level of the quick ratio may vary in different industries, and for this reason the enterprise may wish to compare its quick ratio with those of other businesses in the industry, to the extent that these are publicly available. Some industries may be in a better position to turn fast-moving inventories into sales at short notice, and can therefore tolerate a lower quick ratio without risking short-term liquidity problems. Other businesses that deal in slow moving goods or products that quickly become obsolete may need a higher quick ratio.
Significance of the Quick Ratio for Small Businesses
Many small businesses are start-ups in the first few years of their life, and at this stage liquidity is vital. Many new businesses fail in their first years, because despite their profit potential, they are unable to generate enough cash to meet their debts as they fall due. Calculation of the quick ratio is a fundamental method for checking the liquidity of the company and requires little time as the quick ratio can be calculated easily and the data is readily accessible.
One danger for all small businesses is that of overtrading. A profitable business may buy in large amounts of inventory expecting vigorous growth in sales, but be caught out by the onset of a recession, or changes in public taste and patterns of demand. In this situation, if the business checks its current ratio (current assets divided by current liabilities), the result will show an apparently healthy business, but application of the quick ratio that subtracts inventory from the current assets may show a different picture.
Action to Correct Liquidity Problems
Where the calculation of the quick ratio indicates that the business is in danger of problems arising from illiquidity, the managers should examine ways of ensuring that this does not lead to greater problems. The levels of inventory held should be reviewed, as these levels may be unnecessarily high, and could perhaps be reduced by the introduction of more rational purchasing or delivery systems. This may require the introduction of new software and internal systems to regulate the business processes.
The business could also look for any unproductive assets, such as buildings, machinery or vehicles that are not being used to generate profits, and could sell any assets that are not necessary for carrying on the trade profitably. It might also be possible to look at negotiating improved terms of payment with creditors, so that they can be paid over a longer period. In an increasingly competitive and harsh business climate this may, however, be difficult.
The ease of calculating the quick ratio means that the business can compute this ratio at frequent intervals. The managers of the enterprise can therefore keep a constant watch on its liquidity position. The development of the quick ratio over time can be significant for the business. If the quick ratio is tending to decline as time passes, this can be a danger sign for the enterprise and the reasons for the decline should be examined. However the use of any accounting ratio is only a rough guide to the health of a business, and should be backed up by more detailed analysis as required.
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