Liquidity refers to the ability to meet your financial obligations on time and is an important concept for small-business leaders to grasp. A company that is not liquid can experience many difficulties and can even go bankrupt due to poor cash flow. Liquidity ratios, especially the quick ratio, can give business leaders and investors a look at a firm's liquidity.
Quick Ratio Calculation
The quick ratio, also called the acid-test ratio, gives people a quantitative measure of a company's ability to convert certain assets to cash. Inventories and prepaid assets are not included in the quick ratio calculation, as it is often difficult to liquidate them on short notice . The quick ratio is calculated by adding together cash, accounts receivable and short-term securities and dividing the sum by current liabilities.
A company that is in a strong liquidity position will have a quick ratio of at least 1. A quick ratio of 1 signifies that the company has one dollar of liquid assets for every dollar of current liabilities. As the ratio increases, it indicates a strengthening liquidity position. A company's quick ratio will change often, based upon its business needs. An increase in inventory purchases, for example, will decrease the quick ratio. However, the inventory increase may be in relation to increased customer orders, which will eventually lead to an increase in cash when the company receives payment.
Quick Ratio Below Industry
A company with a quick ratio "below industry" has a ratio that is lower than its industry's average. Financial ratios such as the quick ratio need to be looked at on an industry-by-industry basis, as the quick ratio for a company in one industry may not be comparable to the ratio for a company in a separate industry.
How to Improve Liquidity
If a company has a quick ratio below industry average, it can increase the ratio in several ways. It can invoice its customers promptly and enforce prompt payment on these invoices to increase cash flow and increase the amount of cash available to pay current liabilities. It also should review its overhead costs and nonessential expenses for opportunities to decrease cash outflows, as this has a direct, positive influence on cash levels.
A southeastern Ohio native, Justin Johnson is a finance professional with accounting and financial planning experience in various manufacturing industries. He discovered a love for writing as student at Pensacola Christian College and after learning many lessons in the workplace, he enjoys writing business and finance pieces.