Quick ratios (also known as acid-test ratios) and current ratios are meant for measuring how well a business can meet its short term financial obligations. The quick ratio and the current ratio are part of “liquidity ratios”.
Liquidity ratios in general are used to tell your company the value (cash equivalents) of your liquid assets and give you a quick look into the short term health of your cash flow.
The main difference between quick and current ratios is that quick ratios only use liquid assets in its formula, while current ratios use all current assets.
Let’s dig a little deeper and explain the differences and pros and cons between the two.
How is a quick ratio used?
The quick ratio is a financial metric that measures a company’s ability to pay its short-term obligations using only its most liquid assets. In simple terms, it shows how much a company can pay its bills if it had to sell its most liquid assets (such as cash and marketable securities) immediately.
To calculate the quick ratio, you divide the sum of a company’s cash, cash equivalents, and marketable securities by its current liabilities. The higher the quick ratio, the better a company’s ability to pay its bills in the short term without relying on its less liquid assets (such as inventory). A quick ratio of 1 or higher is generally considered good, meaning a company has enough liquid assets to cover its current liabilities.
Companies use the quick ratio to assess their ability to pay their short-term obligations without relying on their less liquid assets, such as inventory. The quick ratio provides a more conservative estimate of a company’s liquidity compared to the current ratio because it excludes inventory, which may not be easily convertible into cash.
A higher quick ratio indicates that a company has a strong liquidity position, as it has more readily available assets to cover its short-term obligations. On the other hand, a low quick ratio may signal that a company has trouble paying its bills and may be in a weaker financial position.
For investors, the quick ratio provides useful information about a company’s ability to meet its short-term financial obligations, as well as its overall financial health. For managers and owners, the quick ratio can be used as a tool to evaluate their company’s short-term liquidity and make decisions about how to improve their financial position.
The quick ratio is an important financial metric that provides a quick and conservative measure of a company’s liquidity, making it an important tool for both investors and managers.
How to calculate a quick ratio
Quick Ratio = (Current Assets – Liabilities) / Current Liabilities
The quick ratio involves taking your quick assets, subtracting your company’s current obligations, and dividing by your current liabilities.
To calculate the quick ratio, you’ll need to know the cash equivalents of your quick assets from your company’s balance sheet:
- Your available cash and equivalents
- Your cash equivalents’ marketable securities
- Current accounts receivable (AR)
- Your current liabilities
In other words: Quick Ratio = (Cash + Marketable Securities + Accounts Receivables) / Current Liabilities
How is a current ratio used?
The current ratio is a financial metric that measures a company’s ability to pay its short-term obligations using its current assets. In simple terms, it shows how much a company can pay its bills if it had to sell all of its assets immediately.
To calculate the current ratio, you divide a company’s current assets by its current liabilities. Current assets are items that a company expects to convert to cash within one year, such as cash, accounts receivable, and inventory. Current liabilities are debts that a company must pay within one year, such as accounts payable and short-term loans.
A current ratio of 1 or higher is generally considered good, meaning a company has enough current assets to cover its current liabilities. A ratio below 1 indicates that a company may have trouble paying its bills in the short term. The higher the current ratio, the more capable a company is of meeting its short-term obligations.
How to calculate a current ratio
Calculating the Current Ratio is simpler than the quick ratio.
Current Ratio = Current Assets / Current Liabilities
Differences in the calculation
The current ratio is similar to the quick ratio because it helps the strategic finance team understand a company’s ability to cover its financial obligations and short-term liabilities.
The main difference in the calculation is the length of time for conversion.
The current ratio uses any assets that can be converted into cash within one year versus the quick ratio limit of ninety days.
The current ratio also considers long-term assets like inventory in the calculation, so it offers a more general view of the company’s solvency than the quick ratio.
The quick ratio (also known as the acid-test ratio) and the current ratio are both financial metrics used to measure a company’s liquidity, or its ability to pay its short-term obligations.
The difference between them is the types of assets included in the calculation:
The quick ratio is considered to be a more conservative measure of liquidity than the current ratio because it excludes inventory, which may not be easily convertible into cash.
Pros and cons of each
Quick ratio pros:
- Conservative measure of liquidity: The quick ratio is considered to be a more conservative measure of liquidity compared to the current ratio as it excludes inventory, which may not be easily convertible into cash.
- Better evaluation of short-term solvency: The quick ratio provides a better picture of a company’s ability to pay its short-term obligations without relying on its less liquid assets, making it a useful tool for evaluating the company’s short-term solvency.
- Helps in making investment decisions: The quick ratio is an important financial metric for investors, as it helps them make informed investment decisions by providing information about a company’s short-term liquidity and financial health.
Quick ratio cons:
- Limited scope: The quick ratio only considers a limited number of assets and liabilities, and does not provide a complete picture of a company’s financial position.
- Excludes important assets: The quick ratio excludes important assets such as inventory, which may be a significant source of liquidity for some companies.
- May not reflect the company’s true liquidity: The quick ratio may not accurately reflect a company’s true liquidity, as it assumes that all accounts receivable can be collected within 90 days, and that marketable securities can be sold immediately.
Current ratio pros:
- Comprehensive measure of liquidity: The current ratio considers all current assets and current liabilities, providing a comprehensive measure of a company’s liquidity.
- Reflects a company’s ability to pay both short-term and long-term obligations: The current ratio considers both short-term and long-term obligations, making it a useful tool for evaluating a company’s overall financial health.
- Easy to calculate and understand: The current ratio is a simple and straightforward financial metric that is easy to calculate and understand, making it accessible to a wide range of users.
Current ratio cons:
- Not a conservative measure of liquidity: The current ratio includes inventory, which may not be easily convertible into cash, making it a less conservative measure of liquidity compared to the quick ratio.
- May not accurately reflect short-term solvency: The current ratio considers both short-term and long-term obligations, which may not accurately reflect a company’s ability to pay its short-term obligations.
- Can be misleading in certain industries: The current ratio can be misleading in certain industries, such as retail, where inventory turnover is high and current liabilities are large, leading to a low current ratio even though the company may have a strong liquidity position.
In conclusion, the current ratio provides a more comprehensive measure of a company’s liquidity than the quick ratio. However, its limitations are that it might not be completely accurate due to including long term inventory which is dependent on many factors. Therefore, it should be used in conjunction with other financial metrics to get a complete picture of a company’s financial health.
