The quick liquidity ratio is the total amount of a company’s quick assets divided by the sum of its net liabilities, and for insurance companies, it includes reinsurance liabilities. Essentially, it shows how well an insurance company can use its immediately convertible assets—such as cash, short-term investments, equities, and bonds nearing maturity—to meet its financial obligations promptly.
The quick liquidity ratio is also known as the acid-test ratio or the quick ratio.
Key Takeaways
- The quick liquidity ratio represents the total amount of a company’s quick assets divided by net liabilities and reinsurance liabilities.
- This metric is one of the most stringent gauges of a debtor’s ability to satisfy current debt obligations without needing to raise external funds.
- It serves as a vital measure of an insurance company’s ability to cover liabilities with liquid assets.
- A higher quick liquidity ratio indicates a more robust position in meeting financial obligations compared to a lower ratio.
How the Quick Liquidity Ratio Works
Investors can use several different liquidity ratios to assess a company’s ability to convert assets into cash quickly and cost-effectively. The quick liquidity ratio, generally accounting for assets that can be quickly turned into cash without significant loss of value within 90 days, is considered one of the most stringent ways to assess a debtor’s capacity to meet current debt obligations without external capital.
Expressed as a percentage, a higher quick liquidity ratio signifies better liquidity and an enhanced ability to repay any owed money quickly. Companies with low quick liquidity ratios may need to sell off long-term assets or incur new debt to cover sudden increases in liabilities.
Example of the Quick Liquidity Ratio
The quick liquidity ratio is critical for an insurance company’s ability to cover liabilities with easily convertible assets.
Suppose an insurer covers many properties in Florida, and a hurricane hits the region. The insurer would need more cash than usual to pay claims. An insurer with a high quick liquidity ratio would be in a better position to meet these financial demands than one with a lower ratio.
Quick Liquidity Ratio vs. Current Ratio
Similar to the quick liquidity ratio, the current ratio also assesses a company’s short-term liquidity and its ability to convert assets into cash to settle debts. The quick liquidity ratio, being more conservative, takes fewer assets into consideration than the current ratio.
While the current ratio includes assets like inventory and prepaid expenses, the quick liquidity ratio excludes these, focusing only on the most liquid current assets. Consequently, the ratios can differ substantially. Companies with large inventories may have a high current ratio and low quick liquidity ratio, making investors more inclined to prioritize the quick liquidity ratio for a clearer view of the company’s ability to handle sudden financial crises.
Special Considerations
When evaluating insurance companies, it’s crucial to compare firms offering similar product mixes rather than dissimilar ones. Investors should examine the types of policies offered and the company’s strategy for covering liabilities in emergencies. The acceptable range for quick liquidity ratios varies: property insurers typically have ratios above 30 percent, while liability insurers may aim for ratios above 20 percent.
Beyond the quick liquidity ratio, investors should also consider the current liquidity ratio and the overall liquidity ratio to gauge a company’s ability to meet liabilities with total assets. Additionally, reviewing operating cash flows (OCF) and net cash flows can provide insights into how a company manages its short-term liquidity needs through actual cash operations.
Related Terms: acid-test ratio, quick ratio, current liquidity, liquidity ratios, net liabilities.
