Using the Quick Ratio with the Balance Sheet

Quick Ratio (Acid Test)

(Current Assets - Inventory - Prepaid Expenses)/Current Liabilities

Though inventory is a current asset, it is more difficult to liquidate, and values more difficult to determine. Products no longer in demand are often liquidated at steep discounts, which often occur in the retail industry during seasonal changes.

The Quick Ratio, or acid test, is therefore an even more stringent measure of liquidity. This Accounting Ratio only includes those assets that are more easily convertible to cash, called Quick Assets, such as cash equivalents, receivables, and marketable securities. Inventory and Prepaid items are not included in the ratio calculation.

A ratio of 1.5 or greater is considered adequate to cover short term debts, and a ratio of less than one is a clear warning signal that a company may not be able to pay its short-term debts.

Industry standards should always be considered when comparing the ratios. For example, companies in cyclical industries may require higher ratios to remain solvent during downturns.

The below table show the ratios for the Software Industry, Sunny Sunglasses Shop's main competitor, Luxottica Group, the industry average (Specialty Retail, Other), and the S&P 500.

Company	Current Ratio	Quick Ratio
Microsoft	1.7	1.7
Software Industry	1.9	1.9
Sunny Sunglasses Shop	6.7	6.1
Specialty Retail, Other	1.4	.8
Sunglasses Hut Int. (Luxottica Group)	1.0	.8
S&P 500	.9	.7

Industry averages can be found at MSN Money under Financial Results: Key Ratios, and Yahoo Finance under Company: Competitors.

Notice that Microsoft and the Software Industry have the same Current and Quick Ratios, which indicates that software companies have very low inventory levels compared to other assets. The Software Industry has the advantage of maintaining low inventory levels since software is easily reproduced.

Microsoft was known for hoarding cash, up to $40 billion, that resulted in an Acid Test of four. Because ratios that are too high may indicate inefficiency in utilizing assets, investors wanted to know what Microsoft planned on doing with the cash, whether pouring it into R&D for emerging products and markets, or paying dividends back to investors. Microsoft began paying dividends for the first time in its history in January of 2003. According to Microsoft, the company had decided to pay a dividend due to Microsoft's continued growth during the downturn, as well as the resolution of several legal cases that meant Microsoft would not have to reserve as much cash to pay for legal costs. Both the Current Ratio and the Acid Test returned to industry averages with the annual distribution of cash in the form of dividends.

Sunny Sunglasses Shop's ratios are substantially higher than its competitor and industry averages, which may indicate assets are underutilized. To view the Balance Sheet Example for Sunny Sunglasses for a comparison of these Accounting Ratios, click Here to Navigate to the Quick Ratio Example.

To Return to the Financial Ratios Main Page, Click Here.

Click Here to Return to the Home Page.