What is a quick liquidity ratio and why should I care?

It’s hard not to feel overwhelmed by all the jargon and formulas when people start talking about business finances, annual reports and financial ratios, but there are some key numbers that are relatively easy to work out and which can help small businesses make informed decisions.

One of these is the “Quick Ratio” which looks at the ability of a company to pay off its current liabilities when they become due with their current assets – i.e. can they pay their bills with funds they can get their hands on easily.

Typically, something is classed a current asset if it can be turned into cash in fewer than 90 days.

The formula for the ratio looks like this:

Cash + short term investments that can be cashed in + current money owed to them

————————————————————————————————————————

current liabilities

This is classed as a ‘liquidity ratio’ because it shows how much liquid cash a business has or can get easily.

So that’s how you calculate it, but what does it mean?

Usually, the aim for this ratio is for it to be around 1, meaning current assets and current liabilities are about the same.

Any higher than this and the company can meet its short-term liabilities with its assets (which is good), although they might have too much cash sitting around (which means it isn’t being used to fund business growth or improvement) or they might have a problem collecting money owed to them.

Any lower than this and they can’t meet their short-term liabilities and so if these all became due the company would struggle to pay them, and subsequently struggle to pay you.

That’s all nice and straightforward, but just to make things a little confusing, whether the ratio is good or bad also relies a little on the industry that the company is in.

Some industries like retail have low ratios because they negotiate favourable credit terms and so their current liabilities might be higher compared to their assets (in their 2011 accounts, Tesco had a ratio of 0.29 and Wal-Mart 0.2), whereas other industries where speedy growth is key keep liquid assets high so that they can expand quickly (in their 2011 annual reports McDonalds had a ratio of 1.05 and Burger King 1.3)

CreditHQ provides information on assets and liabilities so you can take a look at some of the companies you trade with and see what their Quick Ratio is like, and you can use this alongside the credit and payment indicators to make informed decisions on how to trade with these companies.

Liquidity - water representing finances

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