© 2000 John Petroff
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© 2000 John Petroff |
E- Quick ratio
1) Calculation of quick ratio:
Quick or Acid Test Ratio (QR) is calculated by dividing current assets from which inventory has been excluded, by current liabilities.
QR = (Cash+Marketable Securities+Accounts Receivable) / Current Liabilities
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From Timken_Balance Sheet for 1999 we can derive the numbers and calculate the value of Timken's quick ratio. Cash and marketable securities total $ 7.9 millions, accounts receivable $ 339.3 millions, and current liabilities $ 557.6 millions. This gives a value of quick ratio for Timken in 1999 of QR = ( 7.9 + 339.3 ) / 557.6 = 0.62 |
See review question Q-8E1.1.
2)- Modifications to calculation
The numbers used in the calculation of quick ratio may need some correction for reasons already mentioned for cash balance, and reasons still to come for current liabilities. Since the exact amount of available liquidity is so important in this measure, it is also appropriate to touch upon elements that can affect marketable securities. Usually, these securities are highly marketable and thus it is easy to obtain recent accurate quotations (as opposed to securities held for investment purpose which are found as part of fixed assets and which may involve funds tied in closely held affiliates). In most countries, the accounting rule used for reporting these securities is the cost method. The cost method requires that the purchase price of a security be the basis of its balance sheet valuation unless the current market value is lower, and the decline in value is other than temporary. When such a decline is recorded, an account for "valuation allowance" should be present on the balance sheet. If stocks and bonds have been depressed, and the company does not have the value decline recorded, the analyst may want to question whether the adjustment recommended by accounting rules, has been made. When the stock and bonds have been on an upswing, marketable securities are likely to be understated, but no correction can be expected on the balance sheet. It will be up to the analyst to make his/her own adjustments (provided sufficient detailed information is obtained from the firm).
See review question Q-8E2.1
The quick ratio is a very stringent measure of solvency. When compared to the current ratio, it may reveal the extent to which the firm is dependent on selling its inventory to meet current obligations. Whether or not this is a problem obviously depends on how liquid (i.e. sealable) inventory is, and thus, an additional analysis is always necessary. In fact, this measure is too stringent and narrow to allow meaningful implications about the firm's future. But, a comparison over time may bring to light a deterioration of liquidity foretelling oncoming insolvency, and therefore, it must never be overlooked.
A general rule of thumb suggests that the quick ratio should be around 1. As can be seen in Table T-8.4, the rule of thumb holds for all the industries except one, food stores.
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| Sales $ | G | M | W | R | U | S |
| -1 MM | 0.9 | 1.3 | 0.8 | 0.3 | 0.9 | 1.6 |
| 1-3 MM | 1.1 | 1 | 0.9 | 0.4 | 1 | 1.1 |
| 3-5 MM | 1 | 1 | 1 | 0.5 | 1.1 | 1.8 |
| 5-10 MM | 1.3 | 0.8 | 0.9 | 0.4 | 1.1 | 1.1 |
| 10-25 MM | 1.3 | 0.8 | 0.9 | 0.5 | 1.2 | 1 |
| 25 + MM | 1.2 | 1 | 0.9 | 0.4 | 1.1 | 0.8 |
| G = Manufacturers - Drugs and Medicines SIC 2833 | ||||||
| M = Manufacturers - Machinery SIC 3561 | ||||||
| W = Wholesalers - Furniture SIC 5021 | ||||||
| R = Retailers - Food Stores SIC 5411 | ||||||
| U = Telephone Communication, SIC 4812 | ||||||
| S = Services - Travel Agencies, SIC 4724 | ||||||
| Source: Robert Morris Associates, "Annual Statements Studies, 1994" | ||||||
The fact that quick ratio values are close to the theoretical value of one is surprising in light of the widespread deviations of current ratio values from its theoretical value of two, observed in Table T-8.3. This suggests that the quick ratio is more robust. In fact, the apparent oddity of excessively low ratio for the food stores is not an oddity at all, and should not lead anyone to believe that food stores in the United States will soon close and people won't have any place to buy milk and bread. The reason is simply that food stores did not - up until very recently - sell on credit.
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For an example of quick ratio calculation and values of a non-American firm, let's return to AO Boom GAAP Balance Sheet (the Russian firm studied in Chapter 7). For 1994, we find that cash amounts to 147,505 roubles, marketable securities 28,207 roubles, accounts receivable 9,649 roubles, and total current liabilities 505,375 roubles. This gives a quick ratio of QR = ( 147,505 + 28,207 + 9,649 ) / 505,375 = 0.37 AO Boom quick ratio in 1994 is clearly a ratio much lower than that of most firms in the United States, but is well in line with values of quick ratio for American retail firms. Just as at AO Boom, most of the current assets of retail firms consist of inventories which are financed in good part by vendors. This explains why AO Boom current ratio was healthy at 1.50, and the quick ratio is so slim at 0.37. |
See review questions Q-8E3.1 through Q-8E3.3.
See research assignments R-8E.1 and R-8E.2.
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