“Cash is king.” We hear it all the time. But for small businesses, cash is fuel. And over 80% of businesses that fail do so because of cash flow issues.
This means companies often strike a balance between current assets and current liabilities. You have to have enough in the bank to cover the loan payback.
How do you know you’ve got it covered? A little “quick” math can provide answers.
Specifically: The Quick Ratio and Current Ratio.
Here's what you'll learn:
- Terms you’ll need to know to calculate these ratios
- Why the quick ratio is important
- How companies use the quick ratio vs. the current ratio
- Using the quick ratio vs. current ratio for yourself
- Pros and cons of using the quick ratio or current ratio
- What to do if the quick ratio indicates a liquidity problem
- How to improve your ratios for robust financial performance
- Useful terminology for calculating liquidity ratios
- What is the quick ratio?
- What is the current ratio?
- Pros and cons of the quick ratio
- What about liquidity?
- 7+ ways to strengthen your liquidity ratios
- Conclusion: the quick ratio vs. current ratio
Useful terminology for calculating ratios
The quick ratio and the current ratio fall under the category of financial ratios called "liquidity ratios". A liquidity ratio is a financial metric that determines a debtor's (usually a company's) ability to pay off its debt without external sources of funds.
In other words: what is the value of their liquid assets? What are their cash equivalents?
Before we talk about the quick ratio and current ratio, it helps to understand the terms involved in the calculation. Understanding these terms clearly will help you make correct calculations when you calculate your liquidity ratios.
Current liabilities: These are short-term debts due in less than one year, such as:
- Bank loans
- Owed taxes
- Interest due
- Dividends due to investors
- Accounts payable (money due to vendors for purchases)
For most companies, Accounts Payable is the largest source of short-term liability. These invoices typically have terms ranging from net thirty to net sixty days from receipt of invoice.
Liquidity: The amount of cash, or easily convertible cash equivalents, available on the balance sheet of a business.
Short-term liabilities: Debts a company owes that are due within one year from the date of issue.
Long-term liabilities: Debts a company owes that are due more than a year from the date of issue. Long-term liabilities are often paid in installments (like a bank loan), and the currently due portion of the debt is listed separately on the balance sheet for accuracy.
Solvency: Holding quick assets that exceed liabilities and having the financial ability to pay debts.
What is the quick ratio?
The quick ratio measures a company's ability to pay off its total current liabilities using cash or cash equivalents. It's sometimes called the acid test ratio or acid ratio.
Cash equivalents include easily converted (liquid) assets like:
- CDs, money market funds, banker’s acceptances.
- Marketable securities (stocks and bonds that can be quickly sold)
- Current accounts receivable (money owed from customers but not yet paid).
The quick ratio is a liquidity ratio, as it only calculates the ability to pay using a company’s most convertible quick assets: those that can be converted to cash in less than 90 days (hence the “quick”).
In other words, it only includes a company's most liquid assets. These are sometimes called quick assets or liquid assets.
Why is the Quick ratio important?
You need enough cash in the bank to pay loans, salary, taxes, dividends, and interest payments. After that, you need enough cash on hand to fuel growth. In other words: cash in the bank is an important signal about a company's financial health, even if it isn't the complete picture.
Cash isn’t the end of the story, of course. Many companies use debt to extend their capabilities, increase cash efficiency, and achieve results faster. Prepaid expenses can be a smart way of managing cash flow and a little debt now can mean big savings later. Debt financing allows companies to get the most bang for their buck. It even has some tax advantages.
(Please note: we’re not tax experts. For tax advice or consultation, contact your accountant.)
Calculating the quick ratio forces you to look at your company's liquidity. By taking stock of your immediate obligations, short-term debt, and other short-term financial obligations, you get a better picture of your company's overall financial health.
Why do companies use the quick ratio?
The quick ratio provides an easy temperature check for the business. It identifies potential financial trouble before it happens, giving the company time to act and avoid a cash shortage.
Checking your company's current assets and accounts receivable against its current liabilities is a signal: are you on track, or do you need to sound the alarm?
Another great thing about the quick ratio is that you can calculate it with simple figures found in financial reporting documents.
The quick ratio also tells the finance department if they need to obtain additional financing.
How to calculate quick ratio from the balance sheet
To calculate the quick ratio, you’ll need to know the cash equivalents of your quick assets from your company's balance sheet:
- Your available cash and equivalents
- Your cash equivalents marketable securities
- Current accounts receivable (AR)
- Your current liabilities
Here’s how it works:
Quick Ratio = (Current Assets – Liabilities) / Current Liabilities
Quick Ratio = (Cash + Marketable Securities + Accounts Receivables) / Current Liabilities
So the quick ratio is pretty simple to calculate. Just take your quick assets, subtract your company's current obligations, and divide by your current liabilities.
What is a good quick ratio?
You’re looking for a ratio result of at least 1.
- A result of 1 or higher means the company has just enough liquid assets to break even when paying the bills. A result higher than 1 is gravy—you can pay all your bills with money to spare (great work!) The higher the number, the more buffer.
- If the result is less than 1, the business cannot meet its current liabilities as calculated.
A higher ratio also means the company can access more resources in an emergency (for instance, if equipment needs emergency replacement). The more liquid cash a company has in its accounts, the more agility they have in the face of change.
...what happens if you fail the acid test? Don't worry: we have some suggestions at the bottom of this post.
What is the current ratio?
Another common and useful ratio calculation is the Current Ratio. This is a simpler version of the quick ratio that works as follows:
Current Ratio = Current Assets / Current Liabilities
The current ratio is similar to the quick ratio in that it helps the strategic finance team understand a company's ability to cover its financial obligations and short-term liabilities.
So what’s the difference between quick ratio and current ratio?
The length of time for conversion.
The current ratio uses any assets that can be converted into cash within one year versus the quick ratio limit of ninety days.
The current ratio also considers long-term assets like inventory in the calculation, so it offers a more general view of the company’s solvency than the quick ratio.
Pros and cons of using quick ratio
The acid test ratio is ideal for getting a quick pulse on the business. While it has limitations, there’s a lot to like about its simplicity and reliability.
- Easy comparison and analysis metric: The information to calculate the quick ratio is found in a single document. It uses a simple formula to deliver a snapshot of health.
- Excludes inventory: It can take time to convert inventory into cash. By excluding inventory from the calculation, the quick ratio considers only the fastest paths to liquidity.
- Considers seasonal changes: Some businesses experience cash shortfalls as a result of seasonal flux. With inventory excluded, the quick ratio offers a true picture of the business as it exists.
- Requires supplement data: While the quick ratio is effective, it only reports on the ability to pay immediate liabilities. For a better picture of solvency, it’s important to look at every cash stream available.
- Inventory conversion varies: Some industries and companies may have faster-than-average conversion times for inventory. If this is the case for your business, the quick ratio may not be the most appropriate metric.
- Does not address cash flow: The quick ratio only offers specific insight on cash conversion. It does not consider cash flow sources such as investments and financing.
What about liquidity?
It's critical that the FP&A team keep an eye on their company's quick ratio (and therefore their company's liquidity).
Because knowing the quick ratio means they've measured their current liabilities against their most liquid assets. They know their liquidity position and they know how to head off a liquidity crisis.
In other words: they know their company's ability to pay off their short-term debts with their marketable securities and current assets.
What is a liquidity crisis?
A liquidity crisis occurs when the ratio of a company's current liabilities is greater than its quick assets. In other words: it's when a company's ability to pay its debts is thrown into doubt.
What happens if the quick ratio indicates a firm is not liquid? If your quick ratio comes up as a number below 1, you're in a poor liquidity position.
It's not time to panic.
But it is time to plan.
There are many steps you can take to shore up your company's quick ratio and financial health. You want to remedy a short-term cash shortfall, protect your current assets, reduce your current liabilities, and set yourself up for stronger cash flow in the future.
What to do if your business has liquidity problems
Many companies encounter temporary liquidity issues. If you find yourself facing a shortfall, use one or more strategies to resolve the shortfall and keep payments on track.
Many of these strategies focus on two things: increasing the value of your current assets and decreasing your current liabilities.
1. Consider a price increase
While this won’t work in every situation, look at your pricing and price structure. Increasing pricing puts more cash into the business on a short-term basis. Depending on the business, this may be a temporary, percentage-based increase during a difficult economic period (for instance, many restaurants raise prices during periods of inflation to mitigate rising commodity costs).
In any case, having more money to count on in your accounts receivable ledger is a good thing.
2. Cut expenses
After considering increasing income, look at conserving money by cutting expenses. Some common places to cut costs include marketing and advertising budgets, software subscriptions, office expenses (supplies and services), food services, etc.
3. Restructure upcoming purchases
If you have large upcoming purchases on the horizon, consider (where possible) moving these to an installment purchase plan. While some interest rate charges may apply, you’ll free up the cash earmarked for that purchase. That could bring your short-term assets and liabilities into alignment.
4. Lease instead of buy
Another option for upcoming fixed asset purchases is to arrange a lease versus a purchase. Leasing offers lower payments and more flexible terms. Just be sure you can meet the lease terms such as acceptable use, horse of service, maintenance schedule, etc.
5. Take a loan
For temporary cash shortages, consider a loan to cover the shortfall. Options for a loan include a standard bank loan or an arranged overdraft from your banking institution. Although taking a short-term loan is a viable solution for a temporary shortfall, care should be taken in using loans for continued solvency issues.
6. Offer early payment discounts
If you have considerable accounts receivables in the pipeline, offer your customers a short-term, limited-time discount for early payment. Many customers may welcome the deal, and it will bring in longer-horizon receivables sooner. Early payments boost short-term cash while strengthening customer relationships by offering them a financial incentive.
7. Enlist a factoring company
Factoring companies purchase your outstanding receivables at a reasonable percentage (usually 15% of the invoice). The benefit is that the company assumes responsibility for pursuing funds from slow-paying customers. It provides an instant cash infusion into the company to boost your ratio.
8. Talk to your vendors
If your cash shortfall is a temporary issue, communicate with your vendors. Your suppliers may be able to extend terms or work out an extended payment schedule. Strong supplier relationship management practices can pay off when a temporary issue arises.
9. Sell fixed assets for cash
Look at your current assets and see what you can liquidate for a quick cash infusion. These quick assets may be fixed assets such as equipment, longer-term financial instruments, or other valuable holdings.
7+ ways to strengthen your liquidity ratios
Once the cash shortfall has resolved—or If your quick ratio is weaker than you’d like—there are plenty of options for strengthening your cash position for the long term. More cash in the bank is the “quickest” way to bump up your ratio. But what are the best ways to achieve this?
- Adjust your payment terms: A high days receivable outstanding (DRO) metric means it takes a while to get cash in the door from invoices. If your current terms are above 60 days, it’s time to implement shorter repayment terms for customers. As mentioned above, establishing a permanent early payment discount may incentivize customers, buff your accounts receivable, and boost your cash position.
- Improve AR accounting: Streamlining the financial accounting process gets invoices out the door more quickly to balance your accounts receivable and accounts payable. If your accounting cycle is slow, upgrading your process results in faster processing and, therefore, earlier payment. Timely and accurate invoicing boosts the cash cycle conversion cycle (CCC) of your business.
- Pay off current liabilities: Installment loans are great for extending your capabilities and conserving cash. But paying too many liabilities simultaneously adds up. If possible, pay off long-term liabilities. While payoffs require cash, it takes the liability off your balance sheet, eliminates future interest charges (if any), and frees up cash.
- Reduce inventory (and other prepaid expenses) turnover time: Excess inventory can mean a lot of unrecognized revenue for the business. Start by increasing sales to draw down excess inventory. Then, optimize your replenishment cycle to keep more of your assets as cash. You don't want your inventory and prepaid expenses to sit because they don't generate value for your business.
- Streamline assets: Your current assets hold potential liquidity. Audit your current assets (fixed assets, securities, etc.) and look for opportunities to turn underperforming, marketable securities back into cash.
- Sweep accounts: Money should never be idle. When holding funds for a specific purpose, consider holding them in a sweep account. This is an interest-bearing account that holds reserve funds until they are needed. At such time, you can move them back into a working account for use.
- Limit drawings: A “drawing” means moving cash out of the business for personal use. It is a popular way for single-owner entities or small partnerships to extract money from the business. But drawings create a financial drain on the books. By limiting drawings and reinvesting in the business, the cash position becomes stronger.
- Strengthen your forecasting: Looking ahead and planning your roadmap avoids cash issues before they start. By taking a granular approach to your business finances, you gain more confidence and control in your accounting.
Conclusion: the quick ratio vs. the current ratio
Now you know how to calculate each liquidity ratio.
You know how to perform an acid test to assess your company's liquidity.
And you know the difference between the quick ratio and the current ratio.
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