Tuesday, September 23, 2008

Quick Ratio Formula

A discussion of the formula for quick ratio calculation for the stock market beginner.

Following on from my article on debt to equity analysis, today I'd like to talk about the quick ratio, also known as the acid test ratio or just acid ratio. This measure takes into account the more immediate liquidity or cash flow requirements of a business. Investors should use this tool when conducting their financial analysis of potential stock market investments to confirm a company's ability to meet its short term obligations.

The most common representation of the formula is as follows:

QR = (Current Assets - Inventory) / Current Liabilities
There are other variations (which I'll discuss shortly) but this simple calulation does the trick in most cases. A quick explanation of the above formula is probably in order.

Since we're trying to determine an organization's ability to meet its short term funding requirements, we take cash and cash equivalents and divide them by current liabilities. The reason we subtract inventory is that it may not be easily converted into cash or if it is, it may be at less than face value (think of 50% off sales).

At this point you may be thinking "But what about other current assets which can't easily be converted to cash?". If you weren't thinking that, or if you're now wondering what current assets are, stay with me - I'll try and make this as painless as possible.

This school of thought is where one of the more common variations of the quick ratio comes from.
QR = (Cash + Cash Equivalents + Accounts Receivable) / Current Liabilities
The difference in this representation of the formula is that we are only using truly 'liquid' assets in the numerator. By only using cash, cash equivalents (short term investments and the like) and accounts receivable (short term money owed to the company) we'll be leaving behind the other potentially non-liquid current assets (things like prepayments or income tax benefits which can't really be converted to cash).

So What Is A Good Quick Ratio?

Common wisdom has it that anything over 1 is acceptable. But as with many of these financial ratios and with financial statement analysis in general, they should be compared among companies within the same industry and also for the same company over time (is the position improving or deteriorating). This should be the approach taken with all stock market formulas.

Is A High Quick Ratio Good?

This is very subjective. In general, an excessive quick ratio may mean the business is not using its assets efficiently (I'm sure shareholders would prefer to look after the cash themselves rather than having it sit on some company's balance sheet). But there maybe legitimate reasons to build up a buffer of cash. It might be in anticipation of lean times ahead for example.

The quick ratio is especially important now. As I write this, world stock markets are in turmoil after the collapse of Lehman Brothers. With consumer spending down and debt funding in short supply, businesses need to be able to survive on internal funding now more than ever.

One criticism of the quick ratio is that it doesn't take into account the timing of cash flows. For example, analysis of current liabilities may show a large proportion of short term commitments fall due within 30 days but accounts receivable may be 60 or even 90 days. This mismatch or cash flow timing could cause problems.

An Example:

What follows is the calculation of the quick ratio for Johnson & Johnson (JNJ) based on the 2008 figures from Yahoo Finance.
JNJ QR = (35,817,000 - 5,700,000) / 21,780,000
= 1.4
JNJ QR = (12,646,000 + 412,000 + 13,151,000) / 21,780,000
= 1.2
As you can see, the second version of the formula gives the more conservative result.

I know I've covered some fairly technical stuff today, but if you're serious about making money in the stock market (or perhaps more accurately - not losing money) then you'll need to do your homework. After all, even beginners' stock market investing requires thorough research and the quick ratio provides an important indicator as to the financial health of any business.


Bret Frohlich said...

This is a great post on an important subject.

Every company claims to be "in good shape" right now, often just hours before they become insolvent.

It's time to stop listening to the CEOs and to start checking the balance sheets.

Thanks for sharing this with us.

aussieinvestor said...

Well said Bret. Stock market beginners need to keep in mind that they're buying part of a business, not just a stock symbol. Understanding the underlying financials of a company (using the quick ratio and others) is key to being a successful investor. Thanks for stopping by.


Interesting post

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