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Quick Ratio:

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Contents:

Definition and Explanation:

Quick ratio is also known as liquid ratio or acid test ratio. Current ratio provides a rough idea of the liquidity of a firm so subsequently a second testing device was developed named as acid test ratio or quick ratio. It establishes relationship between liquid assets and current liabilities. In many businesses a significant proportion of current assets may comprise of inventory. Inventory, by nature, cannot be converted into ready cash abruptly. The term liquid assets does not include inventory.

Formula:

Following formula is used to calculate quick ratio:

Quick ratio = Liquid (quick) assets / Current Liabilities

The term liquid or quick assets includes all the current assets minus inventory at prepaid expenses.

Example:

From the following balance sheet calculate (a) current ratio and (b) quick ratio:

Liabilities

$

Assets

$
Equity share capital 2,00,000 Land & building 80,000
General reserve 90,000 Machinery 1,20,000
Sundry creditors 60,000 Cash 10,000
Bills payable 20,000 Bank 30,000
Bank overdraft 30,000 Stock 1,40,000
Provision for tax 5,000 Short-term investments 25,000
Proposed dividend 10,000 Sundry debtors  
Outstanding salaries 5,000 Less provision 36,000
Long term loans 60,000 Bills receivable 10,000
    Prepaid insurance 9,000
    Preliminary expenses 20,000
 
 
  4,80,000   4,80,000

Solution:

Current ratio = Current assets / Current liabilities

Current assets are cash, bank, stock, investments, sundry debtors (net), bills receivable and prepaid insurance.=  $10,000+30,000 + 1,40,000 + 25,000 + 36,000 + 10,000 + 9,000 = $2,60,000.

Current liabilities are sundry creditors, bills payable, bank overdraft, provision for tax, proposed dividend and outstanding salaries

= 60,000 + 20;000 + 30,000 + 5,000 + 10,000 + 5,000

= $1,30,000

Current ratio = 2,60,000/1,30,000

= 2 : 1

Quick ratio = Quick assets / Current liabilities

Quick assets = Current assets - (Stock + Prepaid expenses)

= 2,60,000-(1,40,000+ 9,000)

= $1,11,000

Quick ratio = 1,11,000 / 1,30,000

= 0.85 : 1

Interpretation of Quick Ratio:

As quick ratio eliminates inventory and prepaid expenses for matching against current liabilities therefore it is a more rigorous test of liquidity as compared to Current ratio. When used along with Current ratio it gives a clearer picture of business's liquidity position. Rule of thumb for acid test ratio is 1 : 1 i.e., if business liquid assets are 100 percent of its current liabilities it is considered to be having fairly good current financial position. However care must be exercised in depending upon too much on rule of thumb stated above. Just like any other ratio the interpretation of acid test ratio also depends on circumstances discussed under Current ratio. Interpretation of this ration is also subject to the same factors and conditions as the Current ratio.

More study material from this to
 

More study material from this topic:

Meanings, Nature and Usefulness of Ratios Analysis
Interpretation of Ratios
Important Factors for Understanding Ratios Analysis
Significance and Usefulness Ratios Analysis
Classification of Ratios
Analysis of Short Term Financial Position or Test of Liquidity
Current Ratio
Quick/Acid Test/Liquid Ratio
Absolute Liquid Ratio
Inventory/Stock Turnover Ratio
Debtors / Receivable Turnover Ratio
Creditors / Payables Turnover Ratio
Working Capital Turnover Ratio
Profitability Ratios
Gross Profit Ratio (GP Ratio)
Operating Profit Ratio
Net profit ratio (NP ratio)
Earnings Per Share Ratio
Operating ratio
Expense ratio
Solvency ratios - Test of Long Term Solvency
Debt-equity Ratio
Debt Service Ratio or Interest Coverage Ratio
Fixed Assets Ratio
Debts to Total Funds or Solvency Ratio
Reserves to Capital Ratio
Capital Gearing Ratio
Proprietary Ratio
Accounting Ratios Formulas
Limitations of Ratios Analysis

 

A D V E R T I S E M E N T

 

Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 

 

 

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