Analyzing financial statements can be confusing with so many ratios to choose from. Most financial analysts would agree that current ratio and quick ratio provide valuable insight into a company's liquidity.
In this post, we'll clarify the difference between these two critical metrics and outline when each ratio has the most utility for assessing short-term financial health.
You'll learn the precise formulas behind current and quick ratios and see examples of how each is applied in financial modeling and reporting. We'll also discuss interpretations and limitations to avoid misusing these powerful liquidity indicators.
Introduction to Financial Ratios
Financial ratios are useful metrics that help businesses assess their financial health and performance. Two important ratios for measuring short-term liquidity are the current ratio and quick ratio.
Understanding Current Ratio Meaning
The current ratio measures a company's ability to pay its short-term financial obligations that are due within the next 12 months. It compares a company's current assets to its current liabilities.
Current assets include cash, accounts receivable, inventory, and short-term investments. Current liabilities consist of accounts payable, short-term debt, and other financial obligations coming due within the next year.
The formula for the current ratio is:
Current Ratio = Current Assets / Current Liabilities
A current ratio of 1.0 means current assets perfectly cover current liabilities. A ratio of less than 1.0 indicates potential liquidity issues. Meanwhile, a ratio higher than 1.0 suggests good short-term financial health.
Exploring Quick Ratio: The Acid Test
The quick ratio is a more conservative measure of short-term liquidity. Also called the acid test ratio, it only considers current assets that can quickly become cash. This includes cash itself, accounts receivable, and short-term investments or marketable securities.
The formula for the quick ratio is:
Quick Ratio = (Cash + Accounts Receivable + Short-term Investments) / Current Liabilities
The quick ratio discounts less liquid assets like inventory that take time to convert to cash. So it provides a stricter measure of a company's ability to pay near-term obligations without needing to sell other assets first.
A higher quick ratio indicates better short-term liquidity. A ratio under 1.0 may signal difficulties in meeting urgent financial demands.
Quick Ratio vs Current Ratio Formula
The main difference in the current ratio vs quick ratio formula is which assets are counted in the numerator. The current ratio includes all current assets while the quick ratio focuses strictly on assets that can rapidly convert to cash.
Both metrics provide useful indicators of short-term financial health. The quick ratio helps assess urgent liquidity and potential crises better. Meanwhile, the current ratio evaluates overall working capital to cover total upcoming liabilities.
Which is better current ratio or quick ratio?
The current ratio and quick ratio are both liquidity ratios used to measure a company's ability to pay off its short-term liabilities with its current assets. However, they have some key differences:
Current Ratio
- Measures a company's ability to pay off its short-term liabilities with its current assets over the next 12 months
- Formula: Current Assets / Current Liabilities
- A higher current ratio indicates more liquidity and better ability to cover short-term debts
- A current ratio between 1.2 and 2 is considered healthy
Quick Ratio
- Also called the acid-test ratio, measures a company's ability to pay off short-term liabilities with only quick assets
- Quick assets include cash, cash equivalents, and accounts receivable
- Excludes less liquid assets like inventory and prepaid expenses
- Formula: (Cash + Cash Equivalents + Accounts Receivable) / Current Liabilities
- A higher quick ratio indicates better short-term liquidity
- A quick ratio of 1 or higher is ideal
The quick ratio provides a more conservative measure of liquidity because it only considers assets that can be quickly converted to cash. While the current ratio considers inventory and other assets, the quick ratio ignores assets that would take over 90 days to convert to cash.
Overall, the quick ratio gives a snapshot of a company's immediate liquidity, while the current ratio evaluates longer-term liquidity. Examining both together gives a more complete picture of a company's financial health.
What if quick ratio is less than current ratio?
A quick ratio that is lower than the current ratio could indicate some issues with a company's financial health and liquidity. Here are a few key points:
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The quick ratio only looks at the most liquid current assets, while the current ratio looks at all current assets. So if the quick ratio is lower, it suggests that some of the company's current assets are less liquid or can't be converted to cash quickly to pay off current debts.
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A low quick ratio in particular means the company may not have enough quick access to cash and easily-sold assets to meet its short-term obligations if an urgent need arose. This could put them at financial risk.
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Some reasons why the quick ratio may lag the current ratio:
- The company has a large inventory that is not very liquid.
- Many accounts receivables are overdue or hard to collect on quickly.
- They have assets that are illiquid or would take longer to convert to cash.
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A low quick ratio merits further investigation into the makeup of the company's current assets to understand if there are liquidity issues at play. It may require better management of inventory levels, improving receivables collection procedures, or reassessing their investments in current assets.
In summary, if the quick ratio falls below the current ratio, it suggests the company has some less liquid assets that could negatively impact their ability to pay debts in the short term. Analyzing the reasons behind this liquidity gap is crucial.
What does a quick ratio tell you?
The quick ratio, also known as the acid test ratio, measures a company's ability to quickly convert its most liquid assets into cash to pay off its short-term liabilities.
A higher quick ratio indicates that a company can more easily meet its short-term financial obligations without needing to liquidate less liquid assets like inventory or equipment. Generally, a quick ratio of 1.0 or higher is considered good.
Specifically, the quick ratio looks at a company's:
- Cash and cash equivalents
- Short-term investments
- Accounts receivable
And compares that total to the company's current liabilities like accounts payable, wages, taxes, etc.
The quick ratio provides a snapshot of a company's short-term financial health and liquidity position. Tracking the trend of a company's quick ratio over time can give key insights into its cash management strategies and ability to weather unexpected cash crunches.
Unlike the current ratio, the quick ratio does not include inventory and prepaid expenses since those assets cannot quickly be converted into cash. By only looking at the most liquid assets, the quick ratio aims to provide a more realistic assessment of a company's capacity to pay off debts due in the coming 12 months.
What is a quick ratio that is much smaller than the current ratio reflects?
A quick ratio that is significantly lower than the current ratio typically indicates that a company has a large value of inventory relative to its current assets.
The current ratio measures a company's ability to pay off its short-term liabilities with its current assets, while the quick ratio is more conservative as it excludes inventories and only considers cash and cash equivalents, accounts receivable, and short-term marketable securities.
Inventories are generally less liquid than other current assets like cash. If a company has a large inventory balance compared to its cash and accounts receivable, this will make its quick ratio much lower than its current ratio.
For example:
- Company A has $100,000 in cash, $50,000 in accounts receivable, $150,000 in inventory, and $100,000 in accounts payable.
- Its current ratio is ($100k + $50k + $150k) / $100k = 3.0
- But its quick ratio is ($100k + $50k) / $100k = 1.5
The large inventory balance of $150,000 causes Company A's quick ratio to be half its current ratio. This shows it relies heavily on selling inventory to pay off short-term obligations.
A low quick ratio can make a company vulnerable to a liquidity crisis if it cannot sell inventory fast enough to cover its near term liabilities. Monitoring the gap between current and quick ratios is therefore useful for assessing business health.
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Calculating the Ratios
Step-by-Step Current Ratio Calculation
The current ratio is calculated by dividing a company's total current assets by its total current liabilities.
The formula is:
Current Ratio = Current Assets / Current Liabilities
To calculate it:
- Find the total current assets on the company's balance sheet
- Find the total current liabilities on the company's balance sheet
- Divide the total current assets by the total current liabilities
For example, if a company has $2 million in current assets and $1 million in current liabilities, its current ratio is 2 ($2 million / $1 million).
Generally, a current ratio between 1.5-3 is considered good. A ratio under 1 means the company may have trouble paying its short-term debts.
How to Calculate the Quick Ratio
The quick ratio is calculated by taking only the most liquid current assets and dividing them by total current liabilities.
The formula is:
Quick Ratio = (Cash + Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities
To calculate it:
- Find the company's cash and cash equivalents, short-term investments, and accounts receivable on the balance sheet
- Sum those quick assets
- Divide them by the total current liabilities
For example, if a company has $500,000 in cash, $100,000 in accounts receivable, and $300,000 in total current liabilities, its quick ratio is 2 ($600,000 / $300,000).
A quick ratio between 1-1.5 is generally considered sufficient liquidity to pay short-term obligations.
Analyzing Financial Ratios
Compare a company's current ratio and quick ratio over time to identify trends. Also benchmark the ratios against industry averages.
If the ratios are declining, it may indicate the company is having issues meeting short-term debts. Compare to competitors to determine if the entire industry is facing liquidity issues.
Lower than average ratios could signify higher risks, while companies with high liquidity may not be investing assets efficiently. As with any financial metric, the current and quick ratios should be analyzed in a broader context.
Assessing Liquidity with Ratios
Both the current ratio and quick ratio provide useful insights for assessing a company's short-term financial health and liquidity. Looking at how these ratios change over time and comparing them to industry benchmarks can signal whether a business has enough current assets to cover its upcoming cash outflows.
Liquidity Analysis Using Current Ratio
The current ratio measures a company's ability to pay short-term liabilities with its current assets. A higher ratio indicates more liquidity and financial flexibility.
- The formula is: Current Ratio = Current Assets / Current Liabilities
- A ratio under 1 means liabilities exceed assets and indicates potential liquidity issues
- A current ratio between 1-3 is generally considered healthy
- Major drops in the ratio from one period to the next can forecast cash flow problems ahead
When analyzing the current ratio trends, it's important to consider factors like seasonality, business cycles, and changes in operations. For example, inventory build-ups before peak sales seasons can temporarily increase the ratio.
Evaluating Financial Flexibility with Quick Ratio
The quick ratio is more conservative than the current ratio. It only considers cash and assets that can quickly convert to cash to cover upcoming cash outflows.
- The formula is: Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
- A higher quick ratio indicates more liquidity and ability to respond to unexpected cash needs or opportunities
- A quick ratio under 1 suggests high risk of a liquidity crisis
- Comparing the current ratio to quick ratio over time shows reliance on inventory and other current assets to meet obligations
If the quick ratio is substantially lower than the current ratio, it indicates the business relies heavily on selling inventory to generate cash flow for paying bills. This may pose liquidity risks if inventory starts piling up.
Forecasting Potential Liquidity Crisis
Sharp declines in the current or quick ratio from one accounting period to the next can forecast an upcoming liquidity crisis if the trends continue. This signals current assets are being depleted much faster than replaced.
Comparing historical ratios to industry benchmarks also highlights situations where liquidity is well below what is typical for the business type. If the reason for the low or declining ratios is not easily explained, it may suggest financial difficulty ahead.
Proactively monitoring the current and quick ratios helps businesses identify liquidity threats while there is still time to take corrective actions. This could involve accessing credit lines, reducing expenses, or renegotiating payment terms with suppliers. Taking decisive steps quickly is key to maintaining operations.
Comparative Analysis: Current Ratio vs Quick Ratio
The current ratio and quick ratio are both liquidity ratios used to measure a company's ability to pay off its short-term liabilities with its current assets. However, they differ in the types of assets considered.
Differences in Asset Composition
The current ratio considers all current assets, including:
- Cash and cash equivalents
- Short-term investments
- Accounts receivable
- Inventory
On the other hand, the quick ratio focuses only on current assets that can quickly be converted into cash to pay off liabilities. This includes cash, cash equivalents, and short-term investments. Accounts receivable and inventory are excluded.
As a result, the quick ratio provides a more conservative measure of liquidity. While the current ratio evaluates overall working capital, the quick ratio better assesses a company's ability to meet pressing obligations that require immediate payment.
Measuring Conservatism in Liquidity Ratios
The quick ratio is viewed as more conservative because it only looks at the most liquid current assets that can instantly cover liabilities. This provides a cautious estimate of a company's short-term financial health.
Meanwhile, the current ratio considers assets that may take longer to convert into cash, like accounts receivable and inventory. Although useful for evaluating working capital, these are less helpful for meeting urgent cash needs.
A higher quick ratio signals stronger short-term liquidity and a greater cushion to handle unexpected cash requirements. It reduces the risk that current assets may become illiquid if needed on short notice.
Practical Use Cases for Each Ratio
The current and quick ratios serve related but distinct purposes:
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Current ratio - Assesses overall working capital and the health of day-to-day operations. However, it may overestimate liquidity.
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Quick ratio - Better gauges a company's ability to pay debts and cover obligations if an urgent need for cash arises. Provides a conservative liquidity position.
Investors and creditors may look at both ratios to evaluate different aspects of a company's financial health - its general working capital and quick liquidity. Comparing the two also shows how much current assets are tied up in accounts receivable and inventory versus cash or quick cash equivalents.
In summary, while related, the current and quick ratio have key differences in the assets they consider when measuring liquidity. The quick ratio provides a more cautious view of a company's ability to meet pressing obligations. Evaluating both ratios helps businesses and investors better understand different dimensions of short-term financial health.
Real-World Applications of Ratios
Current Ratio vs Quick Ratio Example in Corporate Finance
The current ratio and quick ratio are important metrics used in corporate finance to assess a company's liquidity and ability to pay off short-term debts.
The current ratio measures a company's current assets against its current liabilities. A higher ratio indicates more liquidity and a better ability to cover short-term obligations. However, it includes assets like inventory which take time to convert to cash.
The quick ratio focuses only on assets that can quickly become cash, like cash itself or short-term investments. It provides a more conservative measure of liquidity.
For example:
- Company A has $2 million in cash, $1 million in accounts receivable, $500k in inventory and $1.5 million in accounts payable.
- Its current ratio is ($2m + $1m + $500k) / $1.5m = 2.67.
- Its quick ratio is ($2m + $1m) / $1.5m = 2.
Company A has good short-term liquidity by both measures. But if sales declined, inventory could pile up and accounts payable may be due before accounts receivable is collected. So the quick ratio highlights risks the current ratio masks.
Corporate finance teams use these ratios to inform decisions about taking on more debt, paying dividends, buying back shares and managing cash flow. Ratios provide an objective way to evaluate liquidity risk.
Financial Review Board: Role of Ratios
Financial review boards at companies, banks and auditing firms analyze financial ratios like the current and quick ratios when evaluating corporate health and risks.
By comparing ratios over time and against industry benchmarks, review boards can spot negative trends. For example, a declining current ratio alongside growing inventory and accounts receivable could suggest liquidity problems ahead.
Review boards might require management changes if ratios reveal deeper issues around working capital management. Weak liquidity could limit growth prospects or require cost cutting.
By monitoring ratios, review boards try to ensure stakeholders have accurate financial reporting. They look for major discrepancies between the current and quick ratios as clues of potential manipulation. Review boards provide oversight and raise red flags to protect shareholder interests.
Quick Ratio vs Current Ratio in SaaS Companies
Software-as-a-Service (SaaS) companies rely on recurring subscription revenue models. They tend to have higher quick ratios than current ratios because they operate with minimal inventory.
SaaS quick ratios can demonstrate:
- Customer concentration risk - If one big client drives a major revenue share, losing them impacts liquidity.
- Burn rate management - Declines in the quick ratio over time could signal excess spending of investor capital.
- Debt capacity - Solid quick ratios give lenders confidence in issuing debt.
However, SaaS current ratios also matter:
- Account receivable risk - Long payment cycles for enterprise contracts can tie up cash.
- Seasonal effects - Billings and revenue may fluctuate quarter-to-quarter.
By evaluating SaaS quick and current ratios together, corporate finance teams gain insights into subscription revenue volatility and levers to pull to accelerate cash flow.
Conclusion: Choosing the Right Ratio
In summary, the current and quick ratios provide useful perspectives on liquidity and short-term financial position. Use both when performing financial analysis.
Final Thoughts on Current Ratio vs Quick Ratio
The current ratio utilizes all current assets while the quick ratio focuses on only those most readily converted to cash. Both ratios have their merits in assessing a company's financial health. The current ratio provides a broader view of liquidity while the quick ratio analyzes only the most liquid assets.
When analyzing these ratios, it's important to consider factors like industry averages, trends over time, cash management efficiency, and the makeup of current assets and liabilities. Using both ratios together can provide deeper insight.
Current Ratio vs Quick Ratio: Which is Better?
There is no definitive answer on which ratio is better or more useful. The current and quick ratios serve complementary purposes. Use both ratios when analyzing liquidity - don't rely on just one.
Apply the ratios within proper context for each company. Compare the ratios to historical trends and industry benchmarks. Review the notes on the financial statements to understand the accounts impacting working capital. With diligent analysis, both the current ratio and quick ratio provide vital perspectives on financial position.
