Whether it’s paying your vendors or covering payroll, you want to be sure you have enough cash (or other easily convertible assets) on hand to keep your operations running smoothly.

Your ability to cover business expenses using existing assets is known as your company’s liquidity. As a business owner, understanding your liquidity helps you ensure your business stays afloat and grows.

The good news is that you don’t need to be a finance professional to calculate or understand your liquidity. Several ratios can give you an understanding of your business’s liquidity, including the quick ratio.

## What is the Quick Ratio?

The quick ratio measures your liquidity by comparing the value of your cash and near-cash assets to your current liabilities. In other words, the quick ratio tells you if you can pay your bills without selling any assets, like inventory, or getting financing.

You may also hear the quick ratio referred to as the acid test ratio after the slang term acid test, which refers to a quick conclusive test that decides the value of something.

## Who Uses the Quick Ratio?

Investors often use the quick ratio as part of their financial research to analyze your company’s financial health while considering potential investment opportunities.

A high quick ratio indicates better financial health. In particular, it means that you can cover your operating expenses and other current liabilities without selling inventory and long-term assets or applying for financial assistance. On the other hand, a lower quick ratio indicates that your business may have trouble paying debts.

Additionally, banks and other lending institutions may calculate your quick ratio when deciding whether to give you a loan. Suppliers may also look at your quick ratio to see if you have a good history of paying off operating expenses.

You need to understand the quick ratio if you’re seeking outside capital or negotiating with suppliers. If you can show your ability to cover short-term obligations without selling long-term assets, that’s a financial strength you can leverage during negotiations.

## How to Calculate the Quick Ratio

The basic formula for calculating your quick ratio (QR) is as follows:

QR = QA / CL

QA = Quick assets and CL = Current liabilities

Current liabilities, also known as short-term liabilities, refer to all financial obligations due within one year. Examples include operating expenses, accounts payable, dividends, and immediate debt payments.

When calculating quick assets, you can use one of two formulas. Both formulas will give you your quick ratio. We recommend choosing the one where the values are easy for you to access.

**Formula 1**

QA = CE + MS + AR

CE = Cash equivalents

MS = Marketable securities

AR = Accounts receivable

**Formula 2**

QA = CA - I - E

CA = Current assets, I = Inventory, and PE = Prepaid expenses

Let’s take a closer look at each one.

### Formula Version 1 Explained

The first example calculates your quick ratio with quick assets as cash, cash equivalents, marketable securities, and a portion of your accounts receivable.

QR = (CE + MS + AR*) / CL

Cash equivalents (CE) are assets with a maturity of three months or less, such as treasury bills. Marketable securities (MS) are short-term investment products that usually mature in one year or less, which means you can sell them for cash without losing any value. Examples of these include stocks, bonds, and money market funds.

*For accounts receivable (AR), only consider the dollar amount you expect to receive within the next 90 days.

If you have a large accounts receivable balance and give your customers 180 days to make their payments, including the account’s total value would inflate your quick ratio, which might provide a false sense of security.

### Formula 1 Sample Calculation

To better understand how this formula works, consider the following example.

Say you own a carpet cleaning business called Handy Carpet Cleaners, and your company’s balance sheet has the following information:

**Quick Assets (QA)**

Accounts receivable (AR*) = $130,000* (of which $60,000 can be collected in 90 days)

Marketable securities (MS) = $7,000

Cash + cash equivalents (CE) = $63,000

**Current Liabilities (CL)**

Accounts payable = $105,000

Accrued expenses = $11,000

Using the first formula, you would calculate your quick ratio as:

QR = (CE + MS + AR*) / CL

QR = ($63,000 + $7,000 + $60,000) / ($105,000 + $11,000)

QR = $130,000 / $116,000

**QR = 1.12**

A quick ratio of 1.12 indicates you have enough quick assets to cover your immediate liabilities. Specifically, it means that for every $1.00 of current debt and expenses, you have $1.12 worth of quick assets to cover it.

### Formula Version 2 Explained

The second formula starts with your current assets (CA) and subtracts those that aren’t considered quick assets.

In other words, you calculate quick assets by subtracting inventory (I) and prepaid expenses (PE) from your current assets (CA or cash plus assets you can convert into cash within one year).

QR = (CA - I - PE) / CL

For accounting purposes, inventory includes your finished products plus raw materials and components. Inventory is not considered a near-cash asset in the quick ratio because you usually have to drastically reduce the price of your products to sell off inventory in 90 days or less.

Prepaid expenses, such as subscriptions and insurance, are considered current assets. However, they’re excluded from the quick ratio formula because you can’t use them to pay off current liabilities.

### Formula 2 Sample Calculation

Let’s take a look at how the second formula works. In this example, imagine your carpet cleaning business has a competitor called Spotless Carpets, and their balance sheet contains the following.

**Current Assets (CA) **

Current Assets (CA) = $125,000

Inventory (I) = $15,000

Prepaid expenses (PE) = $7,000

**Current Liabilities (CL)**

Accounts payable = $120,000

Accrued expenses = $10,000

Using the second formula, you would calculate your quick ratio as:

QR = (CA - I - PE) / CL

QR = ($125,000 - $15,000 - $7,000) / ($120,000 + $10,000)

QR = $103,000 / $130,000

**QR = 0.79**

A quick ratio of 0.79 indicates your competitor does not have enough quick assets to cover immediate liabilities. Rather, for every $1.00 of current debt and expenses, they only have $0.79 of quick assets.

## How to Interpret the Quick Ratio

The normal quick ratio value is 1, which means you have exactly enough cash and liquid assets to pay off your expenses and debts due within 12 months.

A value of less than one indicates you may not be able to pay off your current liabilities completely.

On the other hand, having a quick ratio higher than one indicates higher liquidity and means you have more than enough liquid assets to cover your current obligations.

For example, a quick ratio of 1.2 means you have $1.20 worth of liquid assets on hand to cover every $1 of current obligations.

Ideally, a good quick ratio is 1 or slightly higher. If your company’s quick ratio is too high, it shows you can cover expenses, but you’re not reinvesting assets into business growth. For an investor, this means that your business can cover its debts but may not generate a good return.

## What Does it Mean if Your Quick Ratio is Too Low?

If your quick ratio is less than one, it means that you might have to sell long-term assets to cover your operating expenses and other current obligations. It may also signal that your current business operations don’t generate enough income to keep the company afloat.

Generally, a ratio of less than one tells investors, lenders, and suppliers to view your business with caution.

However, it’s essential to keep in mind that the quick ratio, while valuable, does not paint a complete picture of your financial situation since it doesn’t take into account your industry or business model.

In particular, businesses that move their stock quickly (such as grocery stores) might have a low quick ratio after subtracting inventory but still be able to pay off short-term liabilities.

To get a comprehensive picture of your company’s financial health, investors look at your cash flows and financial statements along with liquidity ratios. Cash flow and financial statements help them understand how your business generates money and how well you manage cash.

## Comparing the Liquidity Ratios

The quick ratio is one of several liquidity ratios used in financial analysis. As the name implies, liquidity ratios measure how well your company can use its assets to pay for liabilities.

The other two most commonly used metrics are the current and cash ratios. Investors, lenders, and potential suppliers may look at all three values when evaluating your business because one approach may be generous and another may be conservative.

### Quick Ratio vs. Current Ratio

The current ratio is also a measure of a company’s financial health. It gauges a company’s ability to pay its current, or short-term liabilities, with its current assets.

Compared to the quick ratio, the current ratio is a more generous estimate of liquidity since it factors in all payments your customers owe plus inventory. The quick ratio, however, excludes inventory and less liquid assets.

If you’re in an industry that has reliably quick inventory turnover, such as transportation, technology, or retail, then the current ratio might be a better indicator of liquidity since you can turn your stock into cash in the short-term.

You can calculate it using the following formula:

Current Ratio = CA / CL

CA = Current assets and CL = Current liabilities

Current assets include cash, cash equivalents, accounts receivable, **inventory**, and other assets you can convert into cash within one year.

A current ratio of 1 indicates that you have enough current assets to cover the expenses and debts owed within the year.

Like the quick ratio, it’s ideal to have a current ratio of 1 or higher, but too high (such as 3 or higher) might indicate that you’re not putting extra income to productive use.

A current ratio of lower than 1 means that your current expenses and debts are greater than your current assets.

### Quick Ratio vs. Cash Ratio

The cash ratio estimates your company’s liquidity by measuring the value of your cash and cash equivalents against the value of your current liabilities. Since the cash ratio does not include short-term assets like accounts receivable and inventory, it’s more conservative than the other estimations.

You can calculate your cash ratio using the following formula:

Cash Ratio = CE / CL

CE = Cash and cash equivalents and CL = Current liabilities

A cash ratio higher than 1 means that you have more cash on hand than current liabilities, whereas a ratio lower than 1 means that your short-term financial obligations exceed your cash.

If your cash ratio is equal to 1, you have precisely enough cash and cash equivalents to cover your current liabilities.

### Liquidity Ratios Example

To see how the three ratios compare, let’s consider the same example we used before with Handy Carpet Cleaners:

**Current Assets (CA)**

Accounts receivable (AR*) = $130,000* (of which $60,000 can be collected in 90 days)

Marketable securities (MS) = $7,000

Cash + cash equivalents (CE) = $63,000

Inventory (I) = $25,000

**Current Liabilities (CL)**

Accounts payable = $105,000

Accrued expenses = $11,000

Looking at just the cash ratio, you might think that your business would be in trouble since you only have $0.54 in cash for every $1.00 of current liabilities.

However, a quick ratio of 1.12 indicates that you’ll be able to cover current expenses and debts by liquidating marketable securities and collecting your receivables.

The current ratio paints an even more optimistic picture of your company’s financial health. A current ratio of 1.94 suggests that once all customer payments and inventory are taken into account, you can cover current liabilities and still have assets left.

By calculating and comparing all three financial ratios, you’ll have a better understanding of your company’s short-term liquidity and understand how much of a role your sales and inventory play in paying for operating expenses.

## In Short: Understanding Your Quick Ratio

Calculating your quick ratio can give you insight into whether or not your business has enough assets to pay for operating expenses and short-term debt. But if you are in an industry that has quick inventory turnover, consider both the quick and current ratio when measuring liquidity.

For more information on tools that can help you manage your day-to-day operating expenses, discover Hourly’s easy full-service payroll solutions today.