Finance and Management - 14

In the last blog, we looked at the meaning of Current ratio. In today's blog, we look at another ratio - The Quick Ratio.

Quick Ratio is defined as:

Quick Ratio = (Current Assets - Inventories) / Current Liabilities

This ratio is also known as the "acid test ratio"

In the explanation of Current Ratio, we have taken up the whole of Current Assets and compared it with the capacity of the company to repay its current liabilities. This gives us an estimate of the short term financial liquidity of the company. However, in the above approach, we realize that there are some industries which have a long sales cycle, and cannot convert the inventory quickly into cash which could be used to clear the short term liabilities.

Given this, it would be prudent to exclude the inventories from the current assets and then take the ratio to assess the short term liquidity of the company. Hence, Quick Ratio/Acid Test Ratio is better method to compare the short term liquidity of the company and there by the ability to repay short term obligations.

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