A quick ratio or acid ratio determine the company ability to meet its short term obligation by converting current assets into cash at short period of time of one month. The need of quick ratio arise to measure the liquidity of the company more accurately by eliminating the some current assets from current assets as mentioned below.
Acid or Quick Ratio = Current assets – Inventory / Current liabilities
The reason for removing inventory from the current assets because sometimes it take lot of time to convert itself into cash. The pile up inventories in the company most of the times increase the current ratio which show wrong indication for this reason it is preferred to use quick ratio in combination of current ratio to determine the difference. Incase if the difference between current ratio and quick ration is huge than it means company majority current assets are in the form of inventory.
In this example company have total current assets of $1000 dollars out of which $400 are inventory and having total liabilities of $1200, the quick ratio will be:
Acid or Quick Ratio = $1000 – $400/ $1200
It means the company can pay off its 50% liabilities through the current assets which clearly shows negative indication. The current ratio greater than 1.0 indicates better liquidity position of the company. Higher the quick ratio better will be the company position to meets its obligation and also attract more investors to plug-in their investment.