Difference between Current Ratio and Quick Ratio
Financial ratios are important to understand how the company is performing financially. The article covers two of the most important financial ratios, current ratio and quick ratio. Also read the difference between current ratio and quick ratio.
Financial ratios are crucial indicators of a company’s financial health. Two important financial ratios that often help businesses determine their financial standings are the Current Ratio and the Quick Ratio. Both measure a company’s short-term liquidity, or its ability to generate enough cash to pay off all debts in the event of maturity in one fell swoop. Although both are measures of a company’s financial health, they are slightly different. Here’s a look at both financial ratios, how to calculate them, and difference between current ratio and quick ratio.
Explore finance courses
Comparison Table
Businesses use the Current Ratio to test their ability to release short-term liabilities, while the Quick Ratio measures a company’s efficiency in meeting its current financial liabilities through its quick assets.
Current Ratio | Quick Ratio | |
Meaning | Current Assets to Current Liabilities. | Highly Liquid Assets to Current Liabilities. |
Tests | A company’s ability to meet short-term financial obligations. | A company’s ability to meet urgent financial obligations. |
Ideal Ratio | 2:1 | 1:1 |
Approach | Flexible. | Conservative and strict. |
Inventory | Includes | Excludes. |
What is the Current Ratio?
The current ratio measures a company’s ability to pay current or short-term liabilities (debt and accounts payable) with its current or short-term assets (cash, inventory, and accounts receivable).
Current assets on a company’s balance sheet represent the value of all assets that can reasonably be converted to cash within one year. Examples of current assets include:
- Cash and cash equivalents
- Negotiable values
- Accounts receivable
- Prepaid expenses
- Inventory
You can calculate a company’s current ratio by dividing its current assets by its current liabilities as shown in the following formula:
Current Ratio Formula –
Current Ratio = Current Assets ÷ Current Liabilities
If a company has a current ratio of less than one, then it has fewer current assets than current liabilities. Creditors would consider the company a financial risk because it may not be able to easily pay its obligations in the short term.
If a company has a current ratio of more than one, then it is considered a lower risk because it could more easily liquidate its current assets to pay short-term liabilities.
What is the Quick Ratio?
The quick ratios also measure a company’s liquidity by measuring how well its current assets could cover its current liabilities. However, it is a more conservative measure of liquidity because it does not include all the elements used in the current ratio. This ratio is also called the acid test ratio. It includes assets that can be converted to cash in 90 days or less.
Current assets used in the quick ratio include:
- Cash and cash equivalents
- Negotiable values
- Accounts receivable
The current liabilities used in the quick ratio are the same as those used in the current ratio, which include –
- Short term debt
- Accounts payable
- Accrued liabilities and other debts
Quick Ratio Formula
The quick ratio is calculated by adding cash and cash equivalents, marketable investments, and accounts receivable, and dividing that sum by current liabilities as shown in the following formula:
Quick Ratio = (Cash + Receivables + Liquid Securities) ÷ Current Liabilities
The quick ratio can still be even if a company’s financials don’t provide a breakdown of its quick assets. You can subtract current inventory and prepaid assets from current assets, and divide that difference by current liabilities.
Similar to the current ratio, a company that has a quick ratio of more than one is generally considered less risky than a company with a quick ratio of less than one.
Conclusion
The use of the current or quick ratio depends on the financial aim of the company. For a significant investment, both relationships can be valuable. If the company want to know if it has enough liquid assets to stay afloat may only need the quick ratio. If it has been determined that the inventory value is likely to remain stable, then only the current ratio will suffice.
Top Trending Finance Articles:
Financial Analyst Interview Questions | Accounting Interview Questions | IFRS Certification | CPA Exams | What is Inflation | What is NFT | Common Finance Terms | 50-30-20 Budget Rule | Concept of Compounding | Credit Cards Rewards System | Smart Budgeting Approaches
Rashmi is a postgraduate in Biotechnology with a flair for research-oriented work and has an experience of over 13 years in content creation and social media handling. She has a diversified writing portfolio and aim... Read Full Bio