Short term liquidity of a company/ firm is usually indicated by the quick ratio which measures the ability of a firm to meet short term obligations/ liabilities with available liquid assets. Now, current assets which cannot be liquidated quickly are to be kept aside of the calculations i.e. subtracted from the current assets. The ratio which measures this is called as “Quick Ratio” or “Liquidity Ratio” or “Acid Test Ratio”, the formula of which is given as under:
Quick ratio = (current assets – inventories)/ current liabilities
Liquid assets are those, which one can convert easily in cash without much loss, hence,
Quick ratio = (cash and equivalents + marketable securities + accounts receivable)/ current liabilities
This ratio measures the rupee amount of liquid assets, which is available to cover up a rupee of current liabilities. It basically defines the ability of a firm as in availability of quick funds for the repayment of current liabilities. Ideally, 1:1 is considered as standard, however the higher the ratio better is the short-term solvency of the firm.
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Breakdown of Quick Ratio
It is considered better than current ratio as current ratio includes inventory. A higher current ratio will not always mean better liquidity position but higher quick ratio will definitely imply the same. In this ratio, the presence of account receivables is a little debatable, as it cannot be considered as a ready source of cash. This is because generally it takes around 30 to 120 days for the clearance and hence should not be taken in the calculations.
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Another point behind it is that, cash and marketable securities have absolute and full value liquidation, but for liquidation of account receivables, the firm may need to give some discount for early payments and hence the market value won’t be the full value of the receivables.
For this point, different firms may use applied formulae for calculations. Similarly, authors also debate for exclusion of longer/ mid term liabilities from the calculation of quick ratio as current liabilities bank overdraft and cash credit need not to be repaid in near future.