In our previous article, we talked about how the current ratio could be a really good measure of a firm’s short-term liquidity and by that, we meant that we basically taking the firm’s current assets and dividing those by current liabilities. We could get a pretty good idea of how well equipped a firm was to meet its obligations in the coming year. So if a firm for example had current assets divided by current liabilities that were greater than one (>1) that tended to suggest that the firm was liquid enough to meet the obligations that were going to be coming due in the next period and in a firm with a higher such ratio than another firm we could say would be more liquid.
There was this issue that the elephant in the room was that current assets include inventory and in times of recession or some kind of shock or problem with the firm, the firm might have difficulty moving its inventory and we might wonder how liquid this inventory is. If the firm can’t sell the inventory in the inventory is included obviously in current assets then the current ratio won’t be the best measure of liquidity because unsold inventory can’t be used to pay off these liabilities that are going to be coming due and that’s kind of why we need a quick ratio or otherwise known as the acid test ratio.
Basically what we’re doing is addressing this issue by just excluding inventory from the computation of current assets and computing a new ratio. When we compute this quick ratio we can think of it in terms of (current assets – inventory) or we can think about it like this in terms of (cash + marketable securities + net receivables) and then we just divide it the same way we did with the current ratio we just have the denominator again as current liabilities and this is going to yield the quick ratio.
Again if you have a higher quick ratio that’s going to imply higher liquidity. Let’s take a look at an example:
With firm one let’s say that we have cash of $100 and for firm 2 we have cash of $80 and then there are marketable securities of $60 for firm 1 and $140 for firm 2 and then net receivables of $170 and $200 for firm 2 and just to make this a little bit easier we’ll just go ahead and subtotal these and then the subtotal is basically (current assets – inventory).
When we do the subtotal we end up with $334 for firm 1 and then for $20 for firm 2. Now we need to know current liabilities and let’s say for firm 1 current liabilities are $300 and then for firm 2 current liabilities are $600. Now we just take our subtotal which is the current assets excluding inventory, we just take that subtotal for firm 1 and divide it by the current liabilities for firm 1, and what does that yield well that’s going to give us our quick ratio of firm 1 which is going to be 1.1 and for firm 2 we do the same thing we divide this $420 by $600 and it yields a current ratio of 0.7. How can we interpret this well the 1.1 for firm 1 that quick ratio is higher than the 0.7 for firm 2 so which implies that firm 1 is more liquid than firm 2.