The quick ratio is a financial tool that acts as an indicator of a company’s ability to meet their short-term obligation. These obligations are known as current liabilities and consists of the total amount due to creditors within the next 12 months. This number is compared with the current assets of the company less inventory. Current assets are those that the company is planning on turning into cash within the next 12 months. This ratio can help both investors and entrepreneurs understand and develop a comprehensive cash management strategy. The important thing to remember is that a company that cannot cover its current liabilities with its current assets will most likely need to liquidate alternative assets or raise additional funding. This ratio differs from the current ratio in that it does not include inventory. This is because inventory is not easily liquified.
How to calculate the quick ratio:
(Current Assets-Inventory-prepaid expenses)/Current Liabilities
Or
(Cash & Equivalents + Marketable securities+ Accounts Receivable)/Current Liabilities
Most companies have a Quick ratio of around 1. This means that they have $1 of current assets to cover every $1 of current liabilities. If a company’s Quick ratio is above 1, that means that they have more current assets than current liabilities. Investors often use this ratio to estimate the likelihood of a company losing their investment. If the ratio is significantly higher than 1 it can indicate that the company is not properly allocating its resources. Some companies also choose to hold extra cash on hand to replace the need for outside loans and financing. A low ratio alternatively indicates that the company doesn’t have enough cash on hand to pay for its current liabilities. One common cause of this is a company over reliance on their purchased inventory. If a company is unable to sell the inventory on hand and has a low quick ratio, it is very likely that they will be unable to repay its debts.
Scenario 1
Trail Wizard’s business model is based completely on same day payments. If we were to begin taking money through accounts payable, we wouldn’t be able to restock our inventory or even cover the costs of transportation.
If we were forced to take accounts payable, the first safety blanket we could use is to increase our initial paid in capital. This extra cash on hand can give us room to allow our customers to pay when they can. The other solution is to charge a large late fee that continues to accumulate large amounts of interest daily. This policy is used by rental car locations such as hertz and enterprise. If a person misses the predetermined deadline, a large fee is placed on their account. This can have a large impact on our customer’s interactions and interpretation of our brand. Therefore, any fees would need to be administered by a member of the management team and be clearly communicated.
In this scenario it is very unlikely that my company would survive. With a large amount of our sales tied up in accounts receivable we would need to seek out alternative funds through outside financing. Our business only operates 4 months out of the year so a customer that hasn’t paid would push into our off season.
Scenario 2
My boss at Ramapo Travel Plaza taught us the importance of positive relationships with suppliers. He would always tell us “you pay for what you get, and you get what you pay for”. He believed that it was important to hold our company to the same standard that we hold our suppliers. This means that if a supplier delivers product that is extra or unexpected, that honesty is crucial. We have sent back and even paid for extra product rather than attempt to take advantage of a supplier error. Paying the suppliers on a structured basis is critical for creating that positive dynamic.
In the case of Trail Wizards, these relationships with suppliers will be key. In the hiking community many products are offered only in select stores or locations. This means any inconsistency on our part can lead to a lose of a major competitive advantage that we hope to hold.
Scenario 3
We want to establish a line of credit that can cover a months’ worth of inventory. The goal would be to sell the inventory and then use the subsequent cash to pay back the creditor before placing another order. Around the end of year 3 is where I see the potential for an outside line of credit. With the straight-line depreciation model, our food truck would hit its salvage value and can be replaced. We want to use this chance to purchase a second truck to boost profits. This would require another investment of $21,065. Rather than waiting for the firm to generate the cash needed, we want to use this opportunity to build credit. Our goal would be to repay this loan before the truck depreciates to its salvage value.
Tom Green Entrepreneurial Blog 