Imagine a scenario where you invest all your money on a company and all of a sudden the company collapses. In an incident like this, only recovery for you will be the funds you will get after liquidizing the company. That is of course only if any money is left for share holders after the company is liquidized.
What can you do to avoid such a situation? You need to know whether the company that you are planning to invest has enough money and assets from which you can recover your money at the time of liquidation. Then there comes the important question; is there any index that shows liquidity of the company?
Yes, ‘Quick Ratio’ is the indicator used for identifying the liquidity of any company. This ratio is calculated by taking the sum of current assets and accounts receivable, and then dividing it by current liabilities. This method specifically excludes the inventory.
Usually, a quick ratio of 1 or higher is healthy for a company and it indicates that the company does not have to rely on the sale of the inventory to pay the bills. If the quick ratio is lower than 1, that means the company is in trouble and probably the new investors should keep away.
The formula for quick ratio is:
Quick Ration = (Accounts Receivable + Cash Equivalents + Cash)/(Accruals + Accounts Payable + Notes Payable)
There are also a few exceptions when it comes to quick ratio. As we understood, quick ratio indicates the liquidity of the company. But there are cases in which quick ratio does not give you the correct picture. Imagine a company with no bills due today, but having a lot of bills to be paid tomorrow. If you calculate the quick ratio today, the figure will show as having a good liquidity. But in reality, this company cannot be considered as having a good liquidity because of it’s uncounted liabilities that are pending.