Quick ratio
Also written Acid test ratio · Acid-test ratio
Current assets excluding inventory, divided by current liabilities — a stricter liquidity test than the current ratio, because inventory cannot reliably be turned into cash in a hurry.
In plain language
The question behind the quick ratio is blunt: if every short-term creditor asked to be paid this month, could the company pay?
The current ratio answers that by counting inventory as though it were cash. It usually is not. Unsold stock in a warehouse is worth its book value only if somebody buys it at full price, which is exactly what is not happening when a company is short of cash. The quick ratio simply removes inventory and asks the question again.
How it works
Anything reliably convertible to cash within about 90 days counts: cash and bank balances, marketable securities, and receivables from customers who are expected to pay. Inventory and prepaid expenses are excluded.
A reading around 1.0 means short-term obligations are covered without selling any stock. The right level varies enormously by industry — a supermarket runs comfortably at 0.3 because it sells for cash and pays suppliers later, while a capital goods maker with long receivable cycles needs far more.
The formula
Quick ratio = (Current assets − Inventories) ÷ Current liabilities
Current ratio = Current assets ÷ Current liabilities
A worked example
A garment manufacturer's balance sheet at 31 March:
| Item | Rs crore |
|---|---|
| Cash and bank | 40 |
| Trade receivables | 260 |
| Inventories | 520 |
| Current assets | 820 |
| Current liabilities | 600 |
Current ratio = 820 ÷ 600 = 1.37 — looks safe.
Quick ratio = (820 − 520) ÷ 600 = 300 ÷ 600 = 0.50 — is not.
Half the short-term bills are covered. The other half depends entirely on selling Rs 520 crore of last season's garments. In a bad season those clear at 40% off, and the company is short roughly Rs 200 crore.
Why NISM asks about it
Chapter 8 covers the liquidity ratios as a group. Questions typically hand you a balance sheet and ask for one or both ratios, or ask which ratio is the more conservative test of liquidity — the quick ratio, always.
Common exam traps
- Inventory is the only thing removed in the standard NISM treatment. Do not also strip receivables unless the question says so.
- A quick ratio below 1 is not automatically bad — it is normal for retail and for any business that collects cash before it pays suppliers.
- The ratio is a snapshot at one date. A company can borrow just before year-end to flatter it.
- Receivables are only as good as the customers. A quick ratio of 1.5 built on debtors who have not paid for 200 days is worse than one of 0.8 built on cash.
Check yourself
1.Which of the following measures the ability of a company to satisfy its short-term obligations as and when they come due?
- a)Current ratio
- b)Return on equity
- c)Return on capital employed
- d)Inventory turnover ratio
Show the answer
Answer: (a) Current ratio
The current ratio — current assets divided by current liabilities — is the liquidity measure. It is also known as the working capital ratio. The stricter version is the quick ratio, which removes inventories because they cannot be converted to cash immediately.
ROE and ROCE are return ratios: they measure productivity of capital, not the ability to pay bills. Inventory turnover is an efficiency ratio: how many times inventory is rolled over.
One caution the workbook adds and the exam likes: a current ratio below 1 is not automatically bad. A company that takes cash on sales and pays suppliers on credit will show one, and that is a very good situation in which the company's working is funded by its customers.
Where this is taught
Free preparation for NISM Series XVRelated terms
- Core working capitalInventory plus trade receivables minus trade payables — the money permanently trapped in the operating cycle, stripped of cash and borrowings, which have nothing to do with trading.
- EBITDAProfit from running the business, measured before interest, tax, depreciation and amortisation — so before how the company is funded and how it accounts for its assets.
- Return on EquityProfit after tax as a percentage of shareholders' net worth — what the company earned on the money its owners have left in it.
- Liquid Net WorthThe part of a merchant banker's net worth deployed in unencumbered liquid assets, counted after a prescribed haircut on each asset type — a second capital test that net worth alone cannot satisfy.