We all know that the working capital management in a company is all about balancing current assets with current liabilities. Current assets are the short term trade asset like cash, marketable securities, debtors and inventories. Current liabilities are in the form of bills payable, short term loans etc. Typically, the sign of a stable company is one where the current assets are able to take care of the current liability payouts. That is because; it does not make sense to rely on longer term assets and investments to repay your short term liabilities. Hence the most popular ratio that is used is the Current Ratio.
Current Ratio = Current Assets / Current Liabilities
If the Current ratio is more than 1, it is a signal that the company is in a comfortable situation to handle its current liabilities with the help of its current liabilities. But not all current assets are liquid. For example, cash and marketable securities can be easily liquidated and used. In case of debtors, you can insist on some of them to pay up on time. But the real problem comes with respect to inventories. Typically, any company holds an inventory of raw materials and finished goods. These are specialized products and are used in the production and sales cycle. Hence, they cannot be easily liquidated. Therefore, the current ratio may not give a proper picture of the liquidity position of the company. So, is there a better ratio that we can consider? The answer lies in the Quick Ratio! Let us focus on what is a good quick ratio and what does the quick ratio inform you about the company. Let us also look at the quick ratio interpretation.
What exactly is the quick ratio?
Quick ratio only considers those current assets that can be easily liquidated and converted into cash. The formula for Quick Ratio can be written as:
Quick Ratio = (Cash + Marketable Securities + Debtors) / Current Liabilities
In other words, the quick ratio can also be rewritten as..
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
Quick ratio is also known as the Acid Test Ratio and is an indicator of how quickly the company is in a position to liquidate its current assets and repay all its current liabilities.
Quick Ratio with a live Balance Sheet of XYZ Ltd.
LiabilitiesAmountAssetsAmountAccounts Payable15,00,000Cash8,00,000Short term loans4,00,000Marketable Securities8,00,000
Inventories45,00,000Current LiabilitiesRs.19,00,000Current AssetsRs.66,00,000
In the above instance let us calculate the current ratio and the quick ratio and see what the difference actually means?
Current Ratio = Rs.66,00,000 / Rs.19,00,000 = 3.47
If you look at the current ratio, it does appear to be quite comfortable as the current assets are sufficient to cover the current liabilities 3.47 times over. But are these current assets really liquid? Let us now look at the quick ratio.
Quick Ratio = Rs.21,00,000 / Rs.19,00,000 = 1.11
The quick ratio reveals that the liquid assets of the company are just about sufficient to cover the current liabilities and that is not a very comfortable scenario. This finer aspect of the company’s liquidity position becomes clear only when one looks at the quick ratio.
What does a low quick ratio indicate?
Let us take the above case of XYZ Ltd. It has a comfortable current ratio of 3.47 but a quick ratio of just 1.11. Why this discrepancy. Nearly 2/3rd of its current assets are locked up in the form of inventory. This could have two reasons. The raw materials may be either cyclical in availability and hence the company may be playing it safe by stocking more of the raw materials. This could be leading to a rise in inventory. Alternatively, the off-take of its manufactured products may be slower than the production leading to accumulation of inventory with the company. Either ways, this gap between the current ratio and the quick ratio clearly points that the company needs to tighten its inventory management system.
Is it healthy to have a high quick ratio?
Just as a low quick ratio is not a good sign, similarly a high quick ratio is also not a very good sign. Here is why! If the quick ratio is high because of too much cash and near-cash then it is inefficient use of resources. Cash and near-cash do not generate returns and they can be put to better use in the business. It could also be that the debtor levels are too high. That means the company may be lax in collections or may be forced to give very liberal credit terms to its customers. Both are not healthy signs.
It could also mean that the company has taken on current liabilities less than they can afford. That means, the company can afford to give more liberal credit terms to improve sales. That is a signal that the sales and marketing team need to look into urgently.