Why is the quick ratio important?
There are numerous qualitative measures that can indicate expected financial performance when evaluating credit risk in new and existing business relationships. However, it’s important to consider the key metrics that accompany the 5 Cs of Credit.
In addition to the debt service coverage ratio and net profit margin, it is important to measure and monitor a firm’s quick ratio.
What does this mean?
A basic measure of a firm’s liquidity, the quick ratio measures all of the firm’s assets (cash and otherwise) that could be used almost immediately to pay off debts relative to the firm’s short term liabilities.
Why is it important?
Lenders look to the quick ratio because it shows the percentage of a firm’s debts that could be paid off by quickly converting assets into cash. Lenders often look at this ratio because the more liquid a firm’s assets, the better equipped it is to adapt to changing conditions in the business environment.
Ideally, a firm’s quick ratio should be about 1:1, meaning its current assets are just able to cover short-term debts. Low quick ratios are riskier investments because, for those business borrowers, the company’s current debt outweighs current cash reserves. In general, the higher the quick ratio the better because it shows the firm has sufficient cash.
However, be wary of a firm with an especially inflated quick ratio, as it may be an indicator the company isn’t effectively using cash reserves to grow the business.
Learn how to book loans faster while managing risk.
How to improve it?
Since the quick ratio is a measure of liquidity, the following methods can be used to make sure cash and cash equivalent reserves are adequate to cover short-term debts:
• Shore up accounts receivable management to ensure payments are promptly received, which increases cash reserves
• Eliminate unproductive, illiquid assets to free up cash reserves, pay off debts or invest back into growing the business
• Decrease the amount of current debt by negotiating longer-term liabilities
To learn more about which metrics mean the most in your credit analysis process, download the whitepaper Quantifying the 5 Cs: Credit Analysis Ratios That Matter.