Quick Liquidity Ratio

One of reliable formulas used in many companies to determine its liquidity is the calculation of the quick ratio also referred to as the acid test ratio. This ratio indicates the short-term liquidity of the company that is used to measure the ability of the company to meet its obligations towards its liquid assets. In theory, the company’s assets sales would offset a short-term debt in order for the company to continue to operate. Lenders, financial analysts, executive managers and investors rely on the ratio formula as a basis for standard management on accounting. Fixed or not fixed assets such as property, building and equipment are not a part of the calculation of the quick ratio since they are not convertible to cash.

In the insurance company, the calculation for quick liquidity ratio is through dividing the quick assets by the net liabilities and the balance payables of the ceded reinsurance. These quick assets include the unaffiliated common stocks of 80%, unaffiliated bonds developing in a year, unaffiliated short-term investments, government bonds developing in five years and a sum of money. These quick assets may be converted to money right away if emergency occurs.

Calculating the ratio of the company includes the sum of current assets minus the total inventory divided by the total liabilities. The resulting fraction or number is what we call the quick ratio, shown in fraction or whole number. Fractional ratios usually indicate that the company has the tendency on not to be able to pay the debts.

Upon analyzing the financial risk of an organization, analyzing the quick ratio is considered a rigorous activity compared to analyzing the working capital ratio since the quick ratio only includes cash equivalents and cash and excludes the factors such as equipment, inventories and fixed assets. Even if the quick ratio is one of the most useful method of measuring the financial health of the company, those businesses having high level of inventory like the restaurants and retail stores, are somewhat disadvantaged in using this analysis, showing greater risk in their overall solvency profile. Financial analysts usually advice warning to most companies having a quick ratio that is lower compared to its working ratio since this would mean that the company’s assets are basically tied up with its inventory which may affect the liquidity in term of emergency.

People who have the capability to lend cash to companies usually utilize the quick ratio in evaluating if the company can pay or not the debts made in quick and bad situations. Another thing to remember is the perception of the quick ratio is solely role-based. While some lenders may prefer to use the cash-to-liability ratio that is higher than 1.0 since this indicates that the company would most likely be able to repay a debt demanded in an urgent way, the shareholders of the company might choose to go for a cash-to –liability ratio that is lesser than 1.0 since this will indicate that the management of the company is utilizing the assets to keep the business from growing.