The current and quick ratios are good indicators of the short-term liquidity of a business. These ratios can also provide help in analyzing the long-term solvency as well.
Both ratios use a similar form of current assets and current liabilities. However, the interpretation of both these ratios varies with some key differences.
What is the Current Ratio?
Current ratio is a measure of the short-term liquidity of a business. It refers to the ability of a business to manage its short-term liabilities using its current assets.
The current liabilities of a business are the obligations that become due within one year. Therefore, the current assets will be the assets that can be converted into cash within one year.
The current ratio is directly linked with the working capital management of a business. Both the current assets and current liabilities have the biggest shares of items that directly relate to the working capital.
Thus, the current ratio is also sometimes referred to as the working capital ratio.
The short-term liquidity of a business can also be used as a hint of long-term solvency. However, the solvency measures some other metrics that are long-term in nature as well.
How to Calculate Current Ratio?
The current ratio is a simple link between the current assets and current liabilities of a business.
The formula to calculate current assets is:
Current Ratio = Current Assets / Current Liabilities
Current assets include:
- Cash and cash equivalents
- Accounts Receivable
- Prepaid Expenses
- Marketable Securities
Current Liabilities include:
- Accounts payable
- Interest Payments
- Salaries and Wages
- Advance Received
Both these figures can be directly taken from the balance sheet of a company at any time. However, we can also calculate these figures by using input components one by one.
The first step will be to calculate the current assets of the company. Cash and cash equivalents (CCE) are the most liquid current assets.
The CCE section should include bank deposits, checking/saving accounts, and fixed deposit certificates of the company.
Then, accounts receivable is another major current asset. This figure comes directly from the collection department of the company.
Inventory should be measured using market price and an appropriate accounting method chosen by the company like FIFO, LIFO, etc.
Other current assets like marketable securities and prepaid expenses should also be included in the calculations.
The current liabilities include accounts payable as the major contributor. Accounts payable is the sum of obligations that a business owes to its suppliers and vendors.
Similarly, the current portion of long-term loans that becomes due within one year should be included in this segment. The interest payment of all types of debts should be added as well.
Once both figures are ready, we can use the simple formula to calculate the current ratio of the business for the given accounting period.
Interpretation of the Current Ratio
A current ratio of 2:1 is considered a safe ratio for any business. It means if a business holds twice the current assets as its current liabilities, it maintains a good liquidity position.
Although some analysts consider the current ratio of 1:1 as an adequate measure as well. However, it represents a more conservative approach.
A current ratio of 1:1 means the current assets and current liabilities are the same for a business. It does not refer to an alarming position but it is an indication of the conservative approach that can lead to a risky liquidity situation in the future.
A current ratio of less than 1:1 is considered risky. It shows that a business owes more to others in its current obligations than it owes.
Like any other financial ratio, the current ratio also needs further analysis. It should be compared with suitable industry benchmarks for businesses in the same industry and of the same sizes.
Similarly, trend lines should be used to analyze the trend of the liquidity maintained by the business.
What is a Quick Ratio?
The quick ratio of a business refers to the ability of a business to pay its obligation by using its quick assets.
Quick assets of a business are those assets that can be converted into cash within 90-120 days without compromising their market values.
Therefore, the quick assets represent a more refined form of current assets. This term is widely used by businesses with a more conservative approach to measuring their liquidity.
The quick ratio is also a measure of the short-term liquidity of the business. It measures the quick and liquid assets against the current liabilities of the business.
The term current liabilities is the same for both the current and quick ratios.
How to Calculate Quick Ratio?
We can calculate the quick ratio of a business using the following formulas:
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
We can also calculate these components of the quick ratio in a step-by-step approach.
The first step is to calculate the cash and cash equivalents (CCE). The CCE figure should include currency in hand, bank deposits, certificates of deposits, and other short-term interest-earning bank instruments.
Next, we should calculate the accounts receivable figure. It is the sum of uncollected invoices that your customers owe to you.
Other quick assets like marketable securities can also be included in the quick ratio calculations.
The notable exclusions are inventory and prepaid expenses. Inventory cannot be converted into cash quickly when needed to pay off an obligation.
Similarly, prepaid expenses are a form of current assets but not a quick or liquid asset.
The calculations for the current liabilities are the same as mentioned above.
Once both figures are ready, we can divide the quick assets by current liabilities to find the quick ratio for the current accounting period.
Interpretation of the Quick Ratio
A quick ratio of 1:1 is considered a breakeven point in terms of liquidity. As the quick ratio uses more liquid assets than current assets, the breakeven point in terms of the quick ratio is considered safer.
A quick ratio of above 1:1 is considered a positive liquidity position of a business. Conversely, a quick ratio of less than 1:1 is considered risky.
The quick ratio uses more liquid assets. Therefore, if both ratios are the same, then the quick ratio will offer a more conservative and safer figure with lower liquidity risks as compared to the current ratio.
Current Ratio Vs Quick Ratio – Key Differences
We can now summarize the key differences and similarities between the current and quick ratios.
The current ratio measures the liquidity of a business in terms of its current assets. The current assets can be converted into cash within one year.
The quick ratio measures the liquidity of a business in terms of its quick assets. Quick assets are more liquid in nature as they can be converted into cash within 90 days.
Both formulas use the same approach with a change in their numerators.
Current Ratio = Current Asset / Current Liabilities
Quick Ratio = Quick Assets / Current Liabilities
Quick Assets = Current Assets – Inventory – Prepaid Expenses
Components Included or Excluded
The current ratio includes current assets that mature, expire, or can be converted within one year.
These assets include cash & Cash equivalents, marketable securities, accounts receivable, inventory, and so on.
Quick ratio excludes inventory as it cannot be converted into finished goods and subsequently into cash quickly.
Therefore, the key difference between the two figures is the nature of the assets used. The quick ratio uses more liquid assets as compared to the current ratio.
The denominator of both ratios is the same; current liabilities. There is no change in current liabilities for both ratios.
A current ratio of anything above 2:1 is considered safe. However, since the quick ratio considers more liquid assets and takes a strict approach, a quick ratio of 1:1 or above will be considered safe.
The difference between both ideal ratios comes from the conservative approach taken with the quick ratio. It is used by businesses with more liquidity risks and requirements for cash as compared to other industries.
When it is Used?
The current ratio can be used when measuring the short-term liquidity of a business for a period of one year.
The quick ratio further refines the short-term liquidity and considers the ability of a business to manage liquidity within 90-120 days.
Therefore, a business with more tangible and liquid assets should use the quick ratio. Other businesses with less liquid assets and more intangible assets should use the current ratio.
Both figures offer similar advantages to the analysts as these ratios:
- Offer a snapshot of the short-term liquidity.
- Help in analyzing the long-term solvency of a business.
- Can be used in analyzing the working capital management analysis.
- The quick ratio further refines the liquidity measure with a stricter approach.
- Help convince investors, creditors, and shareholders of the business.
As with any other type of financial ratio, these ratios also offer some disadvantages.
- Internal and external benchmarking requires further analysis.
- Comparisons require a careful approach.
- Both ratios use historic figures that offer little assistance in forecasting.
- Accounting policies and choices can affect both these measures artificially.
- Both ratios get distorted with sudden fluctuations in current assets or current. liabilities.