For businesses wanting to quickly evaluate their liquidity and financial health, the quick ratio is a common measure. The quick ratio simply divides a business's assets that can be quickly converted to cash by the current liabilities that the business needs to pay. The ratio that results provides a considerable amount of insight regarding the ability of the business to pay off any debts it might have.
Quick ratio measures can provide convenient information about working capital and provide insight into a business's potential growth and how well it uses its reserves. Banks use numbers like this to gauge the ability of a company to succeed.
The quick ratio, also known as the acid test ratio, is similar but not quite the same as the current ratio. The quick ratio focuses on producing a liquidity ratio based on what the organization can liquidate almost immediately. The current ratio looks at the total current assets and total current liabilities at that particular point in time.
For small businesses, understanding the quick ratio can help you evaluate your ability to keep your business moving forward successfully. It can also be used by lenders evaluating your business for a small business loan.
You can also turn to Skynova's accounting software to easily track your business's assets and liabilities to quickly determine important calculations like your quick ratio. If you want to know more about how to find this ratio and the value it can provide for your business, keep reading.
Understanding the Importance of Quick Ratios
Quick ratios provide rapid insight into your short-term liquidity. In other words, they evaluate your ability to raise money to pay off debts or bills in the next three months or so. For small businesses, they play a critical role in indicating financial health.
To guide your small business toward financial success, this indicator can help you track your business's growth, invest your resources when available, and stay on top of your accounting records.
How Do You Calculate Quick Ratios?
To calculate your quick ratio, use the following equation:
Quick Ratio = Quick Assets / Current Liabilities
Quick assets refer to business assets that you can liquidate within 90 days. In other words, these are the assets you can convert to cash. Your current liabilities refer to the debts and similar items on your balance sheet that you need to pay within the year.
We'll now walk you through how to gather the information you need to run this equation.
Step 1: Run a Balance Sheet
Begin by running your company's balance sheet. This financial analysis will include the business's assets and liabilities at that time. You can use Skynova's accounting software to run a balance sheet if you don't have one available.
Step 2: Add Up Current Assets
Using your balance sheet and any financial statements, find your quick assets. Remember, these are the assets you can convert into cash within the next 90 days. Some common places to look to find your quick assets include:
- Easily liquitable business investments, such as cash equivalents
- Cash your business has on hand
- Accounts receivable, which can be paid by customers
Step 3: Add Up Current Liabilities
Now, look through the balance sheet and find your business's liabilities and current obligations. These are the current outstanding payments you need to make. Some common places to look for your current liabilities include:
- Monthly loan payments
- Any short-term obligations
- Payments for credit lines
- Accounts payable
- Vendor notes or other payments you need to make
Step 4: Calculate the Quick Ratio
Now that you have your quick assets and current liabilities calculated, you'll want to run your equation. Add up the items in your assets column and then divide that by the items in your liabilities column. Remember, you will want to use the following quick ratio formula:
Quick Ratio = Quick Assets / Current Liabilities
This will provide you with a quick ratio and help you manage your financial obligations. The number you get represents your assets in relation to your liabilities. For example, if your quick ratio is 1, this means both your liabilities and assets equal $1 and you have the short-term cash to pay off your debts. The higher the number, the better your business's financial health.
How Do You Interpret Your Quick Ratio?
Quick ratios vary depending on a number of factors. We'll dive into a few key trends that can impact the ratio you get.
Quick ratio will vary by industry. This particular calculation is considered a conservative figure because it doesn't take current inventory into account. Instead, it focuses on what you can turn into cash almost immediately. Therefore, businesses in industries that rely on high amounts of inventory might find that their quick ratio is lower than other businesses. Instead, it's helpful to compare quick ratio numbers to the industry average and see where you stand.
The level of risk a particular business is willing to take on will also impact the quick ratio. Companies open to risk and more investment will naturally have a lower quick ratio compared to those who conservatively save and end up with a quick ratio well above 1.
Businesses that don't adequately invest the funds they have in their companies might end up with an artificially high quick ratio. These business leaders have the assets on hand to cover their liabilities and extra that can be invested back into the business to encourage growth, but they don't take advantage of this opportunity. Thus, despite having a high ratio, they have minimal company growth.
The economy will have a tremendous impact on quick ratios, as it impacts sales rates, interest rates on loans, and even securing loans in the first place. As businesses evaluate their quick ratios, they should pay close attention to current economic trends to see how they can impact their sales.
Since quick ratios don't count inventory as assets - as they can't be liquidated as quickly as other assets - that means organizations with large amounts of inventory might see their quick ratio appear lower than expected based on other indicators of financial health. Businesses shouldn't only look at their quick ratios ; they should also examine how they compare to others within their industry to gain a more accurate picture of their level of success.
How Do You Improve Your Quick Ratio?
Improving a quick ratio can help you grow your business in a variety of ways. When you have a higher quick ratio, it can mean that you have the cash flow and assets needed to invest in the organization. It can also make the business more appealing for partners and lenders should you need investments in the future.
There are a few ways to improve your quick ratio. The primary objective for many organizations will be to increase their sales and inventory. Carefully evaluating your marketing and sales strategy, analyzing your target customers, and building your digital presence can help you increase your sales rate. This will then increase your cash and accounts receivable rates.
You can also focus on paying off your liabilities quickly. Focusing on reducing the amount you owe on loans or lines of credit - including short-term debt and short-term liabilities - can help you minimize your debt. Paying these ahead of schedule can also help you increase your quick ratio and prepare your business for growth.
Quick Ratio Examples
Quick ratio calculations can be used for businesses in a variety of industries. It can be helpful for many professionals to look at examples to better understand how this calculation can be used to measure financial health.
Consider a small retailer. They have the following assets:
- $2,000 in cash
- $4,000 in invested market securities
- $2,000 in accounts receivable
This retailer also has the following liabilities:
- $1,500 in a real estate loan
- $500 in a line of credit
- $2,000 in accounts payable
- $1,000 in vendor notes
This small business would run the calculation as:
This particular business has a good quick ratio that will likely appeal to lenders and partners while also demonstrating that it's poised for growth and success.
In another example, consider a consulting firm with a budget sheet that looks like this:
- $3,000 in cash
- $4,000 in accounts receivable
- $1,000 in investment market securities
- $4,000 in accounts payable
- $2,000 in lines of credit
- $2,000 in a real estate loan
The quick ratio would be calculated as:
This particular business has just enough in liquid assets to pay their current liabilities, but they don't have much wiggle room or extra funds to invest. They'll want to focus on building their assets to grow.
Let Skynova Help You With Your Small Business Accounting
Understanding your financial ratios, such as the quick ratio, can provide you with easily understood metrics concerning your financial health and your company's liquidity. You'll better see your ability to pay off your debts and opportunities for growth.
As you build your business, Skynova has the accounting software you need to track your expenses and understand your financial health. As you begin to build your business, you can also use our software options and free templates to better track your finances and understand the flow of money in your business. With templates to help you create everything from estimates to invoices, Skynova is an excellent resource to help you build your business.