The current ratio and quick ratio are the two most prominent liquidity ratios that speak about the short-term solvency of a business. They tell stakeholders whether or not a company has enough liquidity to meet its short-term liabilities. Although both play an important role in assessing liquidity, there is a slight difference between the two. The quick ratio is considered to be a more stringent measure of liquidity since it employs the use of highly liquid assets in its formula. This will be clearer once we understand the formula and working of each of these ratios. So let’s see their meaning in the below paragraphs:
Meaning and formula of current ratio
The current ratio measures the commitment of a company to serve its short-term liabilities.
The formula for it is as follows:
Current assets are the assets that are expected to be converted into cash within a year. They normally include cash in hand or cash at the bank, inventories, receivables/debtors, loans and advances, marketable securities, pre-paid expenses, etc.
Current liabilities are the liabilities that are payable within a year. These comprise sundry creditors for goods and services, bills payable, outstanding & accrued expenses, short-term loans such as line of credit, provisions for taxation, proposed and unclaimed dividend, bank overdraft, etc.
As the current ratio indicates the extent to which current assets exceed current liabilities, it is an indicator of the financial stability of a business.
If the current ratio is too low (i.e. when current liabilities are much more than current assets), it gives a danger signal to management conveying that the business does not have enough funds to pay off its short-term obligations. It also negatively impacts the business’s credibility and credit rating. Conversely, if the ratio is too high (i.e. current assets being way higher than current liabilities), it would indicate that a company is inefficient in its employment of funds and that a lot of funds are sitting idle.
A current ratio of ‘2’ is considered ideal for a company, meaning that current assets are twice as that of current liabilities. Although a ratio of ‘1.5’ may also be acceptable provided the company has enough arrangements with bankers to meet any short-term shortage of funds.
Now let’s move on to the formula for quick ratio.
Meaning and formula of Quick ratio
The quick ratio, also known as the acid test ratio, uses liquid assets rather than current assets in the numerator. The ratio is determined by comparing liquid assets to current liabilities.
The formula for it is as follows:
Liquid assets represent those current assets that are readily convertible into cash and, therefore, stock and prepaid expenses are excluded while computing liquid assets. (source)
Liquid assets would include cash in hand, cash at bank, sundry debtors excluding bad debts, and readily marketable securities. Usually, the assets that are convertible into cash within 90 days or less are liquid.
Liquid assets = Current Assets – Inventory – Prepaid expenses
An ideal quick ratio is ‘1’. It means that for every dollar payable towards liabilities in the coming period, you have 1 dollar of liquid assets.
While the current ratio includes all current assets in its formula, the quick ratio includes only liquid assets. With a quick ratio, a business can check if it is capable enough to pay its debt out of the sources available within 90 days or less. It would know how much cash (or near cash) it has to pay off its debts right now or in the next few days.
Comparison table – Difference between the two ratios
The table below shows a list of differences between the two ratios:
|Basis of difference||Current ratio||Quick ratio|
|Formula||Divides current assets by current liabilities||Divides liquid assets by current liabilities|
|Assets||Deals with assets realizable in less than a year||Deals with assets realizable in less than 90 days|
|Inventory and prepaid expenses||Includes in assets||Excludes from assets|
|Example||Current assets are $45,000, Current liabilities are $20,000, Current ratio = $45,000 ÷ $20,000 = 2.25||Current assets are $45,000, Inventory is $12,000, Current liabilities are $20,000, Quick ratio = $33,000 ÷ $20,000 = 1.65 (Liquid assets being $45,000 – $12,000)|
|Liquidity measure||A less stringent measure of liquidity||A more stringent measure of liquidity|
|Ideal ratio||2:1 (or 2)||1:1 (or 1)|
|Debt-paying capacity||Short-term debt-paying capacity can be checked||Instant or urgent debt-paying capacity can be checked|
Which is better?
When we compare the Quick Ratio with the Current Ratio, we see that the quick ratio is a more robust parameter of liquidity. It indicates how much cash or near cash assets are available with a company to pay off its liabilities. Stock and prepaid expenses that take some time to convert into cash are excluded in the formula, thereby giving a stronger and fairer position of liquidity. When we exclude funds blocked in inventory, we get the real cash assets available with a company to satisfy its immediate cash payments.
By comparing a company’s current ratio with the quick ratio, stakeholders can also have an idea about inventory hold-ups. For example, when two companies have the same current ratio but differing liquidity ratios, it implies that the company with the lower quick ratio is overstocking and has a larger portion of unsold stock in comparison to the company with the higher quick ratio.
Current ratio or quick ratio – Which one to use?
Both current ratio and quick ratio are important to evaluate a firm’s short-term financial stability. It can’t be said which of these two ratios is more useful. It all depends upon what you want to evaluate and how you want to tweak the numerator and denominator. If liquidity is all that you are concerned about, then the quick ratio is a more conservative measure of short-term liquidity than the current ratio.
In fact, besides using current assets or liquid assets in the numerator, some stakeholders also tend to use super quick assets. Super quick assets mean current assets other than stock, prepaid expenses, and debtors. Thus, super quick assets mainly include cash, bank balance, and marketable securities. The liquidity ratio using super quick assets is a more rigorous test of a company’s liquidity position. If the ratio is 1, it implies the business can meet its current liabilities anytime.
Not only this, to analyze liquidity in a more effective manner, one should also pay attention to the length of cash conversion or operating cycle. Normally, a reduction in the overall length of the operating cycle could signify an improvement in liquidity position.