Contents:
Quick ratio is
also known as liquid ratio or acid test ratio.
Current ratio provides a rough
idea of the liquidity of a firm so subsequently a second testing device was
developed named as acid test ratio or quick ratio. It establishes relationship
between liquid assets and current liabilities. In many businesses a significant
proportion of current assets may comprise of inventory. Inventory, by nature,
cannot be converted into ready cash abruptly. The term liquid assets does not
include inventory.
Following formula is used to calculate quick
ratio:
Quick ratio = Liquid (quick)
assets / Current Liabilities
The term liquid or quick assets includes all
the current assets minus inventory at prepaid expenses.
From the following balance sheet calculate (a)
current ratio and (b) quick ratio:
Liabilities |
$ |
Assets |
$ |
Equity share capital |
2,00,000 |
Land & building |
80,000 |
General reserve |
90,000 |
Machinery |
1,20,000 |
Sundry creditors |
60,000 |
Cash |
10,000 |
Bills payable |
20,000 |
Bank |
30,000 |
Bank overdraft |
30,000 |
Stock |
1,40,000 |
Provision for tax |
5,000 |
Short-term investments |
25,000 |
Proposed dividend |
10,000 |
Sundry debtors |
|
Outstanding salaries |
5,000 |
Less provision |
36,000 |
Long term loans |
60,000 |
Bills receivable |
10,000 |
|
|
Prepaid insurance |
9,000 |
|
|
Preliminary expenses |
20,000 |
|
|
|
|
|
4,80,000 |
|
4,80,000 |
Solution:
Current ratio = Current
assets / Current liabilities
Current assets are cash, bank,
stock, investments, sundry debtors (net), bills receivable and prepaid
insurance.= $10,000+30,000 + 1,40,000 + 25,000 + 36,000 + 10,000 + 9,000 =
$2,60,000.
Current liabilities are sundry
creditors, bills payable, bank overdraft, provision for tax, proposed dividend
and outstanding salaries
= 60,000 + 20;000 + 30,000 +
5,000 + 10,000 + 5,000
= $1,30,000
Current ratio =
2,60,000/1,30,000
= 2 : 1
Quick ratio = Quick assets /
Current liabilities
Quick assets = Current assets -
(Stock + Prepaid expenses)
= 2,60,000-(1,40,000+ 9,000)
= $1,11,000
Quick ratio = 1,11,000 /
1,30,000
= 0.85 : 1
As quick ratio eliminates inventory and prepaid
expenses for matching against current liabilities therefore it is a more
rigorous test of liquidity as compared to
Current ratio. When used along
with
Current ratio it gives a clearer
picture of business's liquidity position. Rule of thumb for acid test ratio is 1
: 1 i.e., if business liquid assets are 100 percent of its current liabilities
it is considered to be having fairly good current financial position. However
care must be exercised in depending upon too much on rule of thumb stated above.
Just like any other ratio the interpretation of acid test ratio also depends on
circumstances discussed under
Current ratio. Interpretation of
this ration is also subject to the same factors and conditions as the
Current ratio. |