The quick ratio allows you to gauge whether a company can pay its bills in the short-term. In other words, if the company were up against the wall and had to pay their bills, can they do it immediately or would they have to rely on the liquidating longer-term assets?
There are two ways to calculate this ratio:
Cash + Accounts Receivables + Marketable Securities
The second method is to simply take the Current Assets from the balance sheet and subtract Inventories.
Scale of Importance: Medium to High
You may be tempted to think that the higher the number for this ratio the better. It’s certainly better for the number to reflect that the company can pay its bills quickly. However, suppose you calculate the to be 2 or 3. This means that the company can easily pay its bills and still have plenty left over. But, it also suggests the company has a lot of cash. Having too much cash means the company is not putting cash to use in the business. Successful companies optimize their cash to gain the highest returns for investors.
Sometimes, Hoarding Cash is Valid
It is quite possible that businesses will hoard cash in the short-term because they have a plan for its allocation. That’s why you shouldn’t consider this number alone as your basis for investment decisions in the company. It can be used to alert you to investigate further. Read through the financial reports under the Management Analysis and Discussion section and look for any clues within the footnotes. Peruse stock forums such as StockTwits.com to see if you can gain insight as to why the company is hoarding cash. Take what is written in the forums with a grain of salt, though.
Your preference for (or against) owning a company in debt should also guide you when using this number. If you have high tolerance for debt and the company has a history of managing that debt responsibly, then a low Quick Ratio shouldn’t concern you as much. On the other hand, some people don’t like to invest in any company that carries a large debt. If you fall into the no-debt category, you can move on when low numbers are reported by they company.
One way you can feel more comfortable with this number is to see how they performed in previous periods. If the Quick Ratio was 0.5 before, how well did the company perform during time?
Also, keep in mind that balance sheets are a snapshot of a financial position at a specific point in time. The company may have had huge sales since they reported this number. That’s why you should always check the most recent quarterly reports and not focus solely on the yearly reports.
The Quick Ratio gives you a good first look at a company of interest and how its managing its short-term liabilities. It is a great starting point in your analysis.