The quick ratio helps you understand your business’ ability to cover short term debts. Forecasting the quick ratio gives you a tool to look ahead and ensure you can meet any short term debts your business plans to take on to fund its activities.
Why is this so important?
Because it’s easy to focus on just cash, or just profit when forecasting. But it’s important to understand the balance sheet and its ratios to give you a full 360-degree view of your financial future.
It’s very easy to think that the cash flow is the only financial report to forecast, and this couldn’t be further from the truth. While “cash is king”, forecasting just your cash flow can give a very one-sided view of your business.
Forecasting your business is just one half of the battle though, you need to track and measure your performance in line with your business goals.
These are captured in metrics called key performance indicators (KPIs). Identifying which ones to use are part of the path to understanding your forecasts and ultimately, making better business decisions.
In this article, we’ll take a look at a balance sheet KPI called the quick ratio (also known as the “acid test”) and discuss why this is one of the great tools in your forecasting arsenal.
Understanding and calculating the Quick Ratio
No, this doesn’t have anything to do with chemistry or being quick!
In short, the quick ratio shows how much of a company’s current assets are available quickly, hence the name.
Unlike the current ratio, quick ratio removes inventory assets from the current assets side of the equation. This ratio deems inventory less ‘liquid’ than cash or receivables.
You can read more about the current ratio in this article I wrote.
The quick ratio uses the data in your balance sheet to see whether you’ve got enough short term assets to cover short term liabilities.
Why is this important?
If you run your business close to the wire, or for example you receive payments at a later date to provide your goods/services, then one big client doesn’t pay, how will this impact you?
Are you going out of business? Will you have enough cash to tide you over?
The quick ratio will help you ensure that you know whether you can cover your short term cash shortfalls whilst you chase your client!
How to calculate the quick ratio
Thankfully, the quick ratio is rather simple to calculate, here’s how you do it:
(Current Assets – Inventory Value) / Current Liabilities
If you need a refresher on what any of these terms mean, check out my article on current assets.
Let’s take a look at a quick example:
A coffee shop has current assets in Jan 2021 of £8,211.48.
£7,673.87 made up from accounts receivable, £537.61 is from Inventory.
This coffee shop also has current liabilities for the same month of £7,242.96
Using these numbers we can calculate the quick ratio as follows:
8,211.48 – 537.61 = 7,673.87
7,673.87 / 7,242.96 = 1.06 (rounded up to 2 DP)
The quick ratio will likely always be a number near 1.
Above 1 and you have enough to cover your current liabilities, below one you don’t.
It’s not quite as black and white as this though, the context matters.
A ratio of below 1 isn’t always a bad thing – it’s dependent on the industry and your business model.
For example, a business that buys and sells goods might have a low ratio because this ratio doesn’t include current assets such as inventory.
As this is part and parcel of the business model for this type of business a low quick ratio is not such an issue, it just means that the business has a lot of its current assets wrapped up in inventory.
How does the quick ratio help you with forecasting?
Don’t get me wrong, this method isn’t the complete answer to financial forecasting – in fact, it’s only a small piece of the puzzle and as explained in the previous section, its usefulness can depend on your industry. It’s just one of many KPIs you should be looking at.
However, understanding it does give you a good indication of your ability to cover short term debts.
Monitoring this in your forecasts can help you predict cash gaps and shortfalls.
Using the coffee shop example from earlier, here’s how the quick ratio can help you with your forecasting.
The coffee shop has a quick ratio of 1.06 – a comfortable ratio for this type of business.
But 6 months later in the forecast, the shop notices that the quick ratio has dropped to 0.7 – this prompts a closer look at the current assets and liabilities – what has happened to cause this?
Taking a look at the balance sheet, the owner notices some short-term borrowing to fund a broken coffee machine replacement.
Without forecasting, the owner wouldn’t have been able to predict this period.
What’s important here is not that their quick ratio is below one, it’s understanding the cause and the consequences of this. If the shop was to get into trouble financially, it wouldn’t be able to cover its short term debts with its current assets.
By forecasting their quick ratio the shop is alerted to the consequence of their borrowing, and now has the ability to work out a plan to avoid this potential shortfall.
Viewing this as a number in your forecast is far quicker than doing the math, and if your business responds well to a quick ratio test, then it’s a superior KPI to track alongside your forecasts.
The quick ratio is great but it’s not the only one!
One downside of the quick ratio is the fact that it does depend on your industry to determine how effective its reading is – and whilst it’s a great KPI, there are others that are more versatile and can provide equally great insight into your business.
What I’m getting at here is that whilst you might find the quick ratio great for your business, it’s not the only KPI to track.
We wrote an article detailing 7 great KPIs to track in your business here.
You don’t want to have to do the calculations in your head each time you look at your financial reports, so keeping track of these KPIs alongside your forecasts is a must.
Ultimately, using a mixture of ratios and KPIs will bolster your forecasting efforts, so don’t discount them when you come to planning your business!