Financial ratios are important indicators for gauging a company’s financial health. They show the financial position of the company, including its profitability and liquidity position. The two important ratios for measuring a company’s ability to pay short term obligations and liquidity are the current and quick ratios. This article covers the current ratio, quick ratio and current vs quick ratio in detail.
What is a Current Ratio?
The current ratio of firm measures the ability to pay its current or short term liabilities with its current or short term assets. It is also known as ‘working capital ratio. From the various assets available, only current assets are considered for the current ratio calculation. Current assets are the possessions of the company that are easily convertible to cash within a year. On the other hand, short liabilities that are due for payment within a year fall under current liabilities.
Current Ratio Formula:
Current Ratio = Current Assets / Current Liabilities
The values of current assets and current liabilities are available in the balance sheet.
The ideal current ratio for a company should be 2:1. A current ratio of less than one means that the company doesn’t have enough assets to pay off the liabilities.
What is Included in the Current Ratio?
The current ratio is a liquidity ratio that is computed by dividing current assets by current liabilities. Therefore, the two main components of the current ratio are current assets and current liabilities.
Current assets are the assets that are easily convertible to cash within a year. The following assets fall under the current assets category:
- Cash and cash equivalents
- Accounts receivables
- Prepaid expenses
- Marketable securities
Current liabilities are a firm’s short term financial obligations that are due within the next year. The following debts fall under the current liabilities category:
- Short-term debt (due within 12 months)
- Accounts payable
- Accrued liabilities and other debts
How To Calculate Current Ratio?
Following is the formula for Current Ratio
Current Ratio = Current Assets / Current Liabilities.
This means the current assets of a company is divided by the current liabilities of the company.
Current assets include all the possessions of a company which can be liquidated into cash in one year. While current liabilities include all those expenses that become payable in one year. By dividing the current assets with current liabilities, one will know how much of the company’s current liabilities can be paid off using the current assets. Also, the higher the ratio, the better it is. However, the ideal current ratio is 2:1.
Let’s take an example of a company with current assets of INR 1,50,000 and current liabilities INR 80,000. One can calculate the current ratio for this company using the formula.
Current Ratio = 150000/80000
Current Ratio = 1.875
This means the company is in a position to pay off the current liabilities with current assets more than one time.
What is a Quick Ratio?
The quick ratio measures a company’s ability to pay off short term obligations with liquid assets. In other words, the quick ratio is a measure of a company’s liquidity. It is also known as the acid test ratio as it tests the ability of a company to convert its quick assets into instant cash.
Quick ratio considers quick assets and current liabilities for its calculation. Moreover, the ideal quick ratio is 1:1. Anything less than that indicates the company’s liquidity is low.
Quick Ratio Formula:
Quick Ratio = Quick or Liquid Assets / Current Liabilities
Furthermore, the ratio measures the rupee amount of liquid assets available against the rupee amount of current liabilities. Liquid assets or quick assets are those assets that can be instantly converted into cash with a low impact on the price received in the open market. Whereas current liabilities are those expenses that become payable in one year’s time.
What is Included in the Quick Ratio?
The following are the two main components of the quick ratio: liquid assets or quick assets and current liabilities.
These are the most liquid assets that the company owns. They can be are easily convertible into cash in a short period of time. While converting quick assets into cash, the company shouldn’t incur high costs. For an asset to be a quick asset, there should be minimal to no loss in value during the conversion of these assets to cash. Quick assets include the following cash, accounts receivable and marketable securities. In other words, these are current assets without inventory and prepaid expenses.
A company’s short-term obligations that become due in the next year are current liabilities. Also, one can easily find them in the company’s balance sheet. The following types of debt fall under the current liabilities category short term debt, accounts payable, outstanding expenses, and other short-term borrowings.
How To Calculate Quick Ratio?
Following is the formula for quick ratio
Quick Ratio = Quick Assets / Current Liabilities
This means the liquid assets of a company is divided by the current liabilities of the company.
Liquid assets include all those assets that can be convertible to cash without a loss in value. While current liabilities include all those obligations that will be due for payment within one year. By dividing the quick assets with current liabilities, one will know how much of the company’s current liabilities can be paid off using the quick assets. Also, the higher the ratio, the better it is. However, the ideal quick ratio is 1:1.
Let’s take an example of a company with liquid assets of INR 1,00,000 and current liabilities INR 80,000. One can calculate the quick ratio for this company using the formula.
Quick Ratio = 100000/80000
Quick Ratio = 1.25
This means the company is in a position to pay off the current liabilities with quick assets more than one time.
Current Ratio vs Quick Ratio – Difference between Current Ratio and Quick Ratio
Following are the key differences between the Current Ratio vs Quick Ratio:
|Basis of Difference||Current Ratio||Quick Ratio|
|Definition||The current ratio is a liquidity ratio that computes the proportion of a company’s current assets to its current liabilities.||The quick ratio is also a liquidity ratio that computes the proportion of a company’s highly liquid assets to its current liabilities.|
|Approach||The current ratio is comparatively a relaxed approach to determine a company’s debt repayment capacity.||The quick ratio is a stringent and conservative approach to determine a company’s debt repayment capacity.|
|Consideration||Considers assets that are easily convertible to cash within a year.||Considers assets that are easily convertible to cash in 90 days or earlier.|
|Inventory||Includes inventory. Also, the current ratio is naturally high for firms with a strong stock of inventory.||Excludes inventory. Also, the quick ratio is low for firms with a strong stock of inventory.|
|Ideal Result||The ideal ratio is 2:1. However, anything above 1 is good.||The ideal ratio is 1:1.|