Definition of quick relationship


What is the quick relationship?

The rapid index is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets.

Since it indicates the company’s ability to instantly use its near-cash assets (assets that can be quickly converted to cash) to pay its current liabilities, it is also called the litmus test index. A “litmus test” is a slang term for a quick test designed to produce instant results.

Key takeaways

  • The quick index measures the ability of a company to pay its current liabilities without having to sell its inventory or obtain additional financing.
  • The quick ratio is considered a more conservative measure than the current ratio, which includes all current assets as a hedge for current liabilities.
  • The higher the result of the ratio, the better the liquidity and financial health of a company; the lower the ratio, the more likely it is that the company will have difficulty paying its debts.

Understand the quick relationship

The quick ratio measures the dollar amount of available liquid assets versus the dollar amount of a company’s current liabilities. Liquid assets are those current assets that can be quickly converted into cash with minimal impact on the price received in the open market, while current liabilities are the debts or obligations of a company that must be paid to creditors within a period of time. anus.

A result of 1 is considered the normal rapid ratio. It indicates that the company is fully equipped with exactly enough assets to be instantly liquidated to pay its current liabilities. A company with a rapid ratio of less than 1 may not be able to fully settle its short-term current liabilities, while a company with a rapid ratio of greater than 1 may be able to instantly shed its current liabilities. For example, a quick ratio of 1.5 indicates that a company has $ 1.50 of liquid assets available to cover every $ 1 of its current liabilities.

While these number-based indices provide information on the viability and certain aspects of a business, they may not provide a complete picture of the overall health of the business. It is important to look at other associated measures to assess the true picture of a company’s financial health.

The quick ratio calculation

The formula for calculating the quick ratio is:

Q

R

=

C

me

+

SUBWAY

S

+

TO

R

C

L

OR

Q

R

=

C

TO


I


P

me

C

L

where:

Q

R

=

Quick reason

C

me

=

Cash

AND

equivalents

SUBWAY

S

=

Negotiable values

TO

R

=

Accounts receivable

C

L

=

Current liabilities

C

TO

=

Current assets

I

=

Inventory

P

me

=

Prepaid expenses

begin {aligned} & QR = frac {CE + MS + AR} {CL} \ & text {O} \ & QR = frac {CA-I-PE} {CL} \ & textbf {where:} \ & QR = text {Quick ratio} \ & CE = text {Cash} & text {equivalents} \ & MS = text {Marketable securities} \ & AR = text {Accounts receivable} \ & CL = text {Current liabilities} \ & CA = text {Current assets} \ & I = text {Inventory} \ & PE = text {Expenses paid in advance} end {aligned}

QR=CLCme+SUBWAYS+TORORQR=CLCTOIPmewhere:QR=Quick reasonCme=Cash AND equivalentsSUBWAYS=Negotiable valuesTOR=Accounts receivableCL=Current liabilitiesCTO=Current assetsI=InventoryPme=Prepaid expenses

To calculate the quick ratio, place each of the formula components on a company’s balance sheet in the current assets and current liabilities sections. Plug the corresponding balance into the equation and perform the calculation.

While calculating the quick ratio, double check the components you are using in the formula. The liquid asset numerator should include assets that can be easily converted to cash in the short term (within approximately 90 days) without compromising their price. Inventory is not included in the quick index because many companies, to sell through their inventory in 90 days or less, would have to apply deep discounts to incentivize customers to buy quickly. Inventory includes raw materials, components, and finished products.

Similarly, only accounts receivable that can be collected within approximately 90 days should be considered. Accounts receivable refers to the money your customers owe a business for goods or services already delivered.

Impact of customer payment on quick relationship

A business may have a large amount of money as accounts receivable, which can increase the ratio quickly. However, if the customer’s payment is delayed due to unavoidable circumstances, or if the payment has a due date that is a long period, such as 120 days based on the terms of sale, the company may not be able to meet its short term. -Term liabilities. This can include essential business expenses and accounts payable that need immediate payment. Despite having a healthy accounts receivable balance, the quick ratio might actually be too low, and the business could run the risk of running out of cash.

On the other hand, a company could negotiate fast receipt of payments from its customers and secure longer payment terms from its suppliers, which would keep responsibilities on the books for longer. By converting accounts receivable to cash faster, you can have a healthier rapid rate and be fully equipped to pay your current liabilities.

If accounts receivable is a quick and ready source of cash, it is still a debatable topic and depends on the credit terms that the company gives to its customers. A company that needs payments in advance or allows clients only 30 days for payment will be in a better liquidity position than a company that gives 90 days. In addition, the credit conditions of a company with its suppliers also affect its liquidity position. If a business gives its customers 60 days to pay, but has 120 days to pay its suppliers, its liquidity position will be healthy as long as its accounts receivable equal or exceed its accounts payable.

The other two components, cash and cash equivalents and marketable securities, are generally free from these time-limited dependencies. However, to maintain accuracy in the calculation, only the amount that will actually be received in 90 days or less should be considered in normal terms. The early liquidation or premature retirement of assets, such as interest-bearing securities, can result in penalties or discounted book value.

Quick relationship example

Publicly traded companies generally report the quick ratio figure under the heading “Liquidity / Financial Health” in the “Key Reasons” section of their quarterly reports.

Below is the quick ratio calculation based on figures appearing on the respective balance sheets of two leading competitors operating in the personal care industry, P&G and J&J, for the fiscal year ending 2021:

(in millions of dollars) Procter & Gamble Johnson and Johnson
Fast assets (A) $ 15,013 $ 38,761
Current liabilities (B) $ 33,132 $ 42,439
Quick reason (A / B) 0.45 0.91

With a quick ratio of 0.91, Johnson & Johnson appears to be in a decent position to cover its current liabilities, although its liquid assets cannot meet every dollar of short-term obligations. Procter & Gamble, on the other hand, may not be able to pay its current obligations using only fast assets, as its fast ratio is well below 1, at 0.45.

Quick ratio vs. current ratio

The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are generally more difficult to convert to cash. The quick index considers only assets that can be converted to cash in a short period of time. The current ratio, on the other hand, considers inventory assets and prepaid expenses. In most companies, inventory liquidation takes time, although a few companies can change their inventory quickly enough to consider it a quick asset. Prepaid expenses, although an asset, cannot be used to pay current liabilities, so they are omitted from the quick index.

Why is the relationship called “fast”?

The quick index considers only the most liquid assets that a company has available to service its short-term debts and obligations. Liquid assets are those that can be quickly and easily converted to cash to pay those bills.

What assets are considered the “fastest”?

The fastest or most liquid assets available to a business are cash and cash equivalents (such as money market investments), followed by marketable securities that can be sold on the market at any time through the business broker . Accounts receivable are also included, since they are payments that are owed in the short term to the company for goods sold or services rendered overdue.

How are the current and fast ratios different?

The quick index only considers the most liquid assets on a company’s balance sheet and therefore provides the most immediate picture of available liquidity if needed in a pinch, making it the most conservative measure of liquidity. The current ratio also includes less liquid assets such as inventories and other current assets such as prepaid expenses.

What if the quick relationship indicates that a company is illiquid?

In this case, a liquidity crisis can arise even in healthy companies, if circumstances arise that make it difficult to meet short-term obligations, such as repaying your loans and paying your employees or suppliers. An example of a powerful liquidity crisis in recent history is the global credit crisis of 2007-08, where many companies were unable to obtain short-term financing to pay their immediate obligations. If new financing cannot be found, the business may be forced to liquidate assets in a liquidation sale or seek bankruptcy protection.

www.investopedia.com

Share
READ ALSO:  Joe Biden trapped by overheating inflation
About the author

Mark Holland

Leave a comment:


Disclaimer

All information provided on Think Rich. Be Free is for general/informational purposes only. The owner of this website may be compensated through advertising and affiliate programs.

Any reference to third party products, rates and offers may change without notice. Please visit the referenced site for updated information. I receive compensations on advertisements that appear on this site but you are not obligated to click on any link or buy any products that are advertised.

Copyright text 2021 by Think Rich. Be Free..