The quick ratio, also known as the acid test ratio, is a stricter measure of liquidity than the current ratio. By excluding inventory, it shows whether a company can meet its short-term obligations without relying on selling products. This guide explains how to calculate and interpret the quick ratio for better investment decisions.
What is the Quick Ratio?
The quick ratio measures a company's ability to pay current liabilities using only its most liquid assets. It excludes inventory because inventory may take time to sell and may not sell for full value in a distressed situation.
The Formula: Quick Ratio = (Current Assets - Inventory) / Current Liabilities. Some analysts use: (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities.
Why the Name Acid Test?
The term comes from gold mining. The acid test was a quick way to determine if metal was real gold by using acid. Similarly, the quick ratio is a rigorous test to see if a company has real liquidity or if its current ratio is inflated by slow-moving inventory.
Components of the Quick Ratio
Quick Assets (Numerator)
These are the most liquid current assets:
- Cash and cash equivalents: Money immediately available
- Marketable securities: Short-term investments easily converted to cash
- Accounts receivable: Money owed by customers (assuming collectible)
What is Excluded
The quick ratio specifically excludes:
- Inventory: May take time to sell, may sell at a discount
- Prepaid expenses: Already spent, cannot be converted back to cash
Example Calculation
Company ABC has the following:
- Cash: $40 million
- Marketable Securities: $20 million
- Accounts Receivable: $60 million
- Inventory: $80 million
- Total Current Assets: $200 million
- Current Liabilities: $100 million
Current Ratio: 2.0 ($200M / $100M)
Quick Ratio: 1.2 (($200M - $80M) / $100M)
The difference shows how much liquidity depends on inventory.
Interpreting the Quick Ratio
Ratio Below 1.0
A quick ratio below 1.0 means the company cannot cover current liabilities without selling inventory. This could be concerning if:
- The company is in a declining industry
- Inventory is slow-moving or obsolete
- The company has high short-term debt
However, some businesses operate successfully below 1.0 due to strong cash flow cycles.
Ratio Between 1.0 and 1.5
This range is generally considered healthy. The company can meet short-term obligations without relying on inventory sales.
Ratio Above 1.5
A high quick ratio indicates strong liquidity but may also suggest:
- Excess cash not being deployed productively
- Slow collection of receivables
- Under-investment in growth opportunities
Industry Rule: A quick ratio of 1.0 or higher is generally considered safe, but the ideal ratio varies significantly by industry and business model.
Quick Ratio vs Current Ratio
Both ratios measure liquidity, but they serve different purposes:
| Aspect | Current Ratio | Quick Ratio |
|---|---|---|
| Includes Inventory | Yes | No |
| Conservatism | Less conservative | More conservative |
| Best For | Overall liquidity view | Stress test scenarios |
When the Difference Matters
Consider two companies with the same current ratio of 2.0:
Company A:
- Current Ratio: 2.0
- Quick Ratio: 1.8
- Only 10% of current assets are inventory
Company B:
- Current Ratio: 2.0
- Quick Ratio: 0.8
- 60% of current assets are inventory
Company A has much stronger true liquidity despite the same current ratio.
Industry Variations
The importance of the quick ratio varies by industry:
High Quick Ratio Industries
- Technology: Low inventory, high cash (often 1.5+)
- Financial Services: Mostly liquid assets (often 1.0+)
- Consulting/Services: No physical inventory (varies widely)
Lower Quick Ratio Industries
- Retail: Heavy inventory investment (0.3 to 0.8)
- Manufacturing: Raw materials and work-in-progress (0.5 to 1.0)
- Automotive: Large inventory of vehicles and parts (0.4 to 0.8)
The Cash Ratio: Even Stricter
For the most conservative view, some analysts use the cash ratio:
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
This excludes accounts receivable, showing only the most liquid assets. A cash ratio of 0.5 or higher is typically considered adequate.
How to Analyze the Quick Ratio
Step 1: Calculate Both Ratios
Always calculate the current ratio alongside the quick ratio. The gap between them reveals how much liquidity depends on inventory.
Step 2: Track the Trend
Is the quick ratio improving or declining over time? A declining trend could indicate building inventory problems or slowing collections.
Step 3: Compare to Peers
How does the company's quick ratio compare to competitors? Industry context is essential for proper interpretation.
Step 4: Examine the Components
What drives the ratio? High receivables might look good but could indicate collection problems. High cash is liquid but may be underutilized.
Red Flags to Watch For
- Quick ratio well below industry average
- Large gap between current ratio and quick ratio
- Declining quick ratio over multiple periods
- Quick ratio below 1.0 with declining sales
- High receivables relative to cash (collection issues)
Practical Applications
For Investors
Use the quick ratio to identify companies that may face liquidity problems. This is especially important during economic downturns when inventory may not sell quickly.
For Creditors
Banks and suppliers use the quick ratio to assess credit risk. A company with a low quick ratio may struggle to pay bills if business slows.
For Management
Track the quick ratio to ensure adequate liquidity. Set targets based on industry norms and business volatility.
Monitor Liquidity Ratios
Pro Trader Dashboard helps you track quick ratios and other liquidity metrics across your portfolio. Identify companies with strong cash positions and avoid those at risk.
Summary
The quick ratio is a stricter liquidity test than the current ratio because it excludes inventory. A ratio of 1.0 or higher indicates the company can meet short-term obligations without selling inventory. Compare the quick ratio to the current ratio to understand how much liquidity depends on inventory. Always consider industry norms and trends over time.
Ready to learn more? Check out our guide on the current ratio or learn about return on equity.