How the quick ratio works

The current ratio asks whether the assets that should turn into cash within a year cover the bills that fall due within a year. The quick ratio, sometimes called the acid test, asks the same thing after removing inventory:

$$\text{Quick ratio} = \frac{CA - I}{CL}$$

On $600,000 of current assets, $160,000 of inventory and $400,000 of current liabilities, quick assets are $600{,}000 - 160{,}000 = 440{,}000$ and the quick ratio is 1.10. The current ratio is 1.50. Working capital, the same comparison as a subtraction, is $200,000.

Inventory is usually the slowest current asset to turn into cash. It has to be sold, to a buyer who wants it, at something near the price the balance sheet assumed. Cash is already cash. Receivables usually arrive on their own. That is why inventory comes out.

The business ratios calculator on this page prints the current ratio, the quick ratio and the gross margin so a liquid wholesaler is not confused with a high-margin firm that happens to share a current ratio. How the current ratio works is the multiple that keeps inventory in. This page is the one that takes it out.

What liquidity means is the wider idea. How working capital works is the dollar gap.

Keep $600,000 of current assets and $400,000 of current liabilities. Set inventory to $0. The current ratio stays 1.50. The quick ratio is now also 1.50, because nothing is taken out. Working capital is still $200,000. Gross profit on that software-shaped sheet is $1,700,000 on $2,000,000 of sales, an 85 percent margin.

The coverage of the bills did not change. The mix of what is covering them did. A ratio without the inventory line cannot tell a wholesaler from a firm that holds no stock.

Current assets $900,000, current liabilities $450,000, inventory $675,000. Current ratio is 2.00, which looks twice-covered. Quick assets are $900{,}000 - 675{,}000 = 225{,}000$. Quick ratio is 0.50, because most of the current assets are stock against $450,000 of bills. Working capital is $450,000. Revenue $5,000,000, cost of goods $3,900,000, gross profit $1,100,000, margin 22 percent.

A 2.00 current ratio that is mostly inventory is a warehouse, not a cash buffer. The quick ratio is the line that says so. For a grocer that sells its stock in days and pays suppliers later, a 0.50 is ordinary. In a firm holding machine parts that turn over once a year, the identical 0.50 would be a warning.

Current against quick is the two ratios on one sheet.

Prepayments are weaker than inventory, and for a different reason. Inventory can at least be sold to somebody. A year of rent paid up front is consumed rather than converted, so it never becomes cash at all. The common $(CA - I)/CL$ version leaves prepayments in. The stricter form counts only cash, short-term investments and money customers owe.

Either is defensible. Using one on the company and the other on its competitor is not. This calculator uses $(CA - I)/CL$. If a company has paid three years of rent in advance, use the stricter form by hand.

There is no right quick ratio on its own. A grocer runs well under 1 as a matter of course, because supplier credit is funding the shelves. A software firm holds almost no inventory, so its quick ratio and its current ratio are nearly the same number.

Compare a company with itself a year ago, and with companies doing the same work. A quick ratio that has fallen from 1.40 to 0.90 in four quarters says something. The same 0.90 read cold says almost nothing until you know what the company sells.

How gross margin works is the other line on this calculator, from a different statement.

It is not a cash forecast, not a sector screen, and not a claim that 1.10 is healthy. The three sheets are a wholesaler at 1.10 with a 1.50 current ratio, a no-inventory sheet that prints 1.50 on both, and a 2.00 current ratio that is a 0.50 quick ratio. This is educational material, not financial advice.