Home Plumbing Contractor Free Plumbing and Heating Contractor Business Strategy Questionnaire 8.4 Quick Ratio Analysis Questionnaire
What is the Quick Ratio and why is it included in a business plan for a Plumbing and Heating Contractor?
Just like the Current Ratio, the Quick Ratio is a key ratio for a small business like Central Plumbing & Heating Inc. It is a key measure of the liquidity of the operations of a small business. It is even more conservative then the Current Ratio and is calculated by taking the current assets and subtracting the inventory from those current assets; and then dividing the balance by the current liabilities of the small business. The resulting number shows how many times the leanest current assets of Central Plumbing & Heating Inc. will cover the current liabilities of the firm. As a general rule, the higher the Quick Ratio the greater the cushion between the current obligations of a small business like Central Plumbing & Heating Inc. and the firms ability to pay them.
The Quick ratio is also known as the acid test ratio since it is this test that determines the company true ability to stay afloat during cash crunches and meet the current liabilities during its course of operations. If a small business like Central Plumbing & Heating Inc. is able to meet this acid test then it has a very good chance of surviving tough or slower economic climates.
If the Quick Ratio of a small business like Central Plumbing & Heating Inc. is low - what does it mean for a business owner like Felix Gonzalez?
A low Quick Ratio means that they may not be enough assets to cover the current liabilities - thus in those times of a crunch where the current liabilities were to exceed the current assets adjusted for inventories, the firm would have a very tough time meeting these liabilities and would have to resort to liquidating their inventory at a steeper discount and perhaps taking a loss in the process just to be able to satisfy its current obligations.
While this may seem like a mundane item - the liquidation of inventory under pressure is something every small business hates to undertake. When the need for urgent cash flow is intense, the business can either turn to its financing sources like a line of credit or a new business loan, or then borrow money against its inventory - the only other option is of course to sell off its existing inventory at a discounted price to bring in the cash. This situation occurs every day for businesses all across the United States and that is why the Quick Ratio / Acid Test Ratio is so key in determining the financial health of a small business like Felix Gonzalez.
We highly recommend that even if the Quick ratio for a small business like Central Plumbing & Heating Inc. is on the higher side, that they take the time to evaluate their cash flow requirements and make sure that they have adequate financing available to take advantage of opportunities that may present themselves in the course of normal business. For example if you are a clothes manufacturer working in the very competitive garment district of New York, a line of credit may allow you to have enough cash to meet your current liabilities when things are slow giving you an edge over the competition that does not have that buffer.
Does the Quick ratio of a small business like Central Plumbing & Heating Inc. affect its competitiveness?
Yes. If a small business like Central Plumbing & Heating Inc. has a higher quick ratio / acid test ratio than its competitors, it means that it will be able to cover its current liabilities much more easily than the competition. What this of course means is that during tougher times, while the entire industry in a target market like Mecklenburg County may be facing a slowdown in sales, and a decline in revenue - Central Plumbing & Heating Inc. will be able to stay comfortably afloat and meet its obligations while its competitors may perish due to their lower cushions.
This is a very significant point that many small business owner like Felix Gonzalez fail to understand - having a good cushion simply means that ability to withstand a period of uneven cash flow is much greater and cash is king. Small businesses that are able to withstand the tougher times are the ones that come out on top and often take down market share when other more leveraged businesses are struggling to survive.
What is a current asset for a small business like Central Plumbing & Heating Inc. located in Mecklenburg County, North Carolina?
A current asset for a small business like Central Plumbing & Heating Inc. located in Charlotte, North Carolina is any asset that can be liquidated within one year or earlier. There are other definitions of current assets but we prefer to use this one. We also recommend that small business owners look at the quality of the current assets carefully before classifying them as current assets.
Thus if the small business owner like Felix Gonzalez or a business like Central Plumbing & Heating Inc. happen to have stocks, bonds and other financial assets that it can readily liquidate, they can most certainly use that in the calculation of a current assets. On the other hand if they happen to own a partnership interest in a venture capital fund or real estate, they should not include the in their current assets since these cannot be liquidated quickly.
There may be a temptation to include an asset like an automobile or other machinery in the current asset number with the thinking that you can raise some money relatively quickly by selling them off for a discount to the market - that would be a mistake. Automobiles and other machinery are classified as fixed assets and cannot be disposed off quickly and should not be included in the current asset calculation.
Typically inventory, accounts receivables, cash and cash equivalents are what are used by a small business owner like Felix Gonzalez in the current assets. However in order to calculate the Quick Ratio / Acid Test Ratio we have to adjust the current assets amounts by reducing the value of the inventory.
What is a current liability for a small business like Central Plumbing & Heating Inc. located in Mecklenburg County, North Carolina?
A current liability for a small business like Central Plumbing & Heating Inc. located in North Carolina, North Carolina is any liability that may have to paid within one year or earlier. Thus all notes, bonds, business loans and other payables that have to be paid within one year are classified as current liabilities. Payments of loans, lines and obligations that are longer in duration are not classified as a long time liability.
There are some business loans that require that a business clean up of loan for a period of 30 days every year - since this requires the business to pay down the entire or part of the note for a duration of the month, we recommend that it be classified as a current liability. On the other hand a typical line of credit that does not require a clean up would not be classified as current liability.
If there is a balloon payment due on a 3, 5 or 7 year note then it must be classified as a current liability for the year in which the balloon payment is due. The rationale for this is simple - for all the other preceeding years only the interest and principal payments impact the business but the note itself is not due till the very end.
The proper classification of current liabilities is essential to be able to understand the nature of the pressure it will have on the cash flow of the business. Items like salaries, interest, accounts payable and other debts due with one year like debts, loans, trade credit would all be considered to be current liabilities for a small business like Central Plumbing & Heating Inc..
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