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Measures a company’s ability to meet its debt obligations.[sc:kit02 ]
Quick Ratio Formula
Explanation of Quick Ratio
Also called the Acid-Test Ratio, the current ratio compares all the Total Current Assets of a company to all the Total Current Liabilities just like the Current Ratio, but the Inventories are subtracted from the Current Assets. Why? Not every company can quickly convert its Inventories into cash in the event it had to pay all its Current Liabilities.
The Quick Ratio is a more rigorous method to test the company’s ability to meet its current debt load. You can make the test even tougher by also subtracting off the Accounts Receivable and prepaid expenses. This will pretty much leave only the truly current and liquidable assets.
Importance of Quick Ratio
If a company you are analyzing looks good while testing it against the Current Ratio, then the Quick Ratio should be your next test to apply. Companies with steadily rising Inventories may look good with the Current Ratio, but will have a deteriorating effect on the Quick Ratio, since we subtract the Inventories out. The Quick Ratio rising over time is favorable.