Liquidity measures how easily and quickly a business can convert its assets into cash at a fair market value.
Liquidity is important to small businesses in a number of situations. In the event of a downturn, for example, having assets that are “close” to cash may allow you to keep paying the bills until your small business bounces back.
The quick ratio is one of the best ways to measure your liquidity position.
Below, you’ll learn:
- Quick ratio definition
- How to calculate the quick ratio
- Why the quick ratio is important
- How to know if you have a good quick ratio
- How to increase your quick ratio
What is the Quick Ratio?
The quick ratio – aka the acid test ratio – compares a company’s liquid assets against its current liabilities.
A higher quick ratio is typically preferable, as this means the company has more liquid assets to cover current liabilities.
What is the Quick Ratio Formula?
Here is the formula for the quick ratio:
Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
Under the quick ratio, current assets that cannot be liquidated in less than 90 days are typically excluded from the numerator. You may have noticed that inventory is absent from the formula – this is because inventory usually cannot be reliably liquidated at fair market value within a few months.
Why is the Quick Ratio Important?
Here are four reasons why the quick ratio is important to small businesses:
- Conservative liquidity measurement: under the quick ratio, you are only relying on assets that can be reliably liquidated. You’re not counting on inventory to pay the bills.
- Shows how you can expect to fare in a downturn: a good working capital ratio is important for small businesses, but here’s the thing: inventory is included in the calculation. And perhaps your small business typically sells inventory predictably. But what happens in the event of a downturn? That inventory you usually sell in three months might sit on the shelves for nine months – making it harder to pay the bills. Yes, accounts receivable (included in the quick ratio) may be harder to collect during tough times – but in general, the quick ratio is a useful “stress test.”
- Tells you if you have enough liquid assets to grow your business: imagine you want to buy a new piece of equipment. You have a strong balance sheet – with assets much higher than liabilities – but what matters is which of those assets can be used to grow your business. By looking at the quick ratio, you know how much cash you have available – or will have available in the near future – to invest in growth opportunities.
- Make changes before it’s too late: a subpar quick ratio increases the likelihood of being unable to satisfy short-term obligations at some point. So, by calculating your quick ratio, you may give yourself an opportunity to improve your liquidity position before it’s too late.
Is a High Quick Ratio Always Ideal?
A higher quick ratio is usually preferable, but a very high quick ratio might not be ideal.
For example, you have a quick ratio of five, meaning you have $5 of liquid assets for every dollar of current liabilities. In this case, your liquid assets are much, much higher than the necessary amount to cover your short-term financial obligations. That might seem like a good thing, but consider the following: a large percentage of those liquid assets might be cash – which could be used to grow your small business.
How do you know if your quick ratio is too high, too low, or just right?
A quick ratio of one is considered good for many small businesses. This means you have exactly the same amount of liquid assets as current liabilities.
But to find out if you have a good quick ratio, you should start by looking at your competitors’ quick ratios (if the information is publicly available). The reason why is that different industries have different liquidity requirements. For example, a recession-proof business might need a lower quick ratio than a business that relies heavily on discretionary purchases.
From there, consider your expected needs. If you have big investments planned for your small business, you might want to shoot for a higher quick ratio. If you don’t expect to need much cash over the next year, a lower quick ratio might be sufficient.
Example of Quick Ratio for Hypothetical Business
Let’s analyze the liquidity of a hypothetical business – Long Inc. – through the use of the quick ratio.
Here is a list of the relevant inputs:
- Cash: $50
- Cash Equivalents: $20
- Marketable Securities: $20
- Accounts Receivable: $40
- Current Liabilities: $100
Remember, the quick ratio is calculated as follows:
Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
Now, let’s calculate the quick ratio.
($50+$20+$20+40) / $100
Quick Ratio = 1.30
At first glance, this seems good.
But Long Inc. has a tourism business, which means that if there is a recession – or a pandemic – the company might need liquid assets to weather the storm. The average quick ratio among its competitors is 1.53. While a 1.30 quick ratio would be sufficient in some industries, Long Inc. might want to look into ways to increase its quick ratio.
How to Increase Your Quick Ratio
To increase your quick ratio, you need to increase your liquid assets and/or decrease your current liabilities. Here are a few tips:
- Increase your operating cash flow: with operating cash flow, a small business can sustainably generate cash. This allows you to build up your liquid assets over time and increase your quick ratio. Look for ways to increase revenue and decrease expenses.
- Optimize inventory levels: imagine you have $100 and you buy $50 in inventory… but you only needed $25 in inventory to satisfy demand. In that case, your cash position could be $25 higher if you kept an optimal inventory level. If you have $100 in current liabilities, that means your quick ratio is .25 ($25/$100) lower than if you bought the right amount of inventory.
- Convert short-term debt into long-term debt: if you have a lot of short-term debt and very little long-term debt, you might want to try to renegotiate your loan terms to convert some of that short-term debt (due within the next 12 months) to long-term debt (due after the next 12 months). This would increase your quick ratio by decreasing your current liabilities.
Final Thoughts
Understanding and optimizing your quick ratio is a great way to strengthen your small business.
But the quick ratio is not the only way to measure the liquidity position of your small business.
In another article, we review the quick ratio and three other liquidity ratios – check it out if you aren’t familiar with the different ways to measure your liquidity position.
