Both the current ratio and the quick ratio are quite similar to each other. The current ratio and quick ratio measure the short term liquidity and financial health (which are mini detached) of a company.
In another word, both ratios indicate the ability to pay off a company's short term liabilities.
The quick ratio is more conservative than the current ratio because the quick ratio includes only quick assets. Hence, the formula of both ratios is slightly different.
Look at the below key differences between the current ratio and quick ratio.
What is the Current Ratio?
The current ratio is a liquidity ratio that reflects the current assets or short term assets that are sufficient to repay the current liabilities within one year.
The current ratio is to be considered a conservative ratio that shows the proportion between current assets and their current liabilities.
It also shows the short-term financial position of the company. The higher the outcome, the greater the financial achievement of the company.
Current assets are those assets that are expected to be converted into cash within 12 months or one year. Current assets are part of the balance sheet of a company.
Few examples of current assets:
- Cash and cash equivalents
- Bills receivable
- Marketable securities
Current liabilities are those liabilities and obligations that have to be paid off within 12 months or one year. It is also part of the balance sheet of a company.
Few examples of current liabilities:
- Bills payable
- Short-term loans
- Bank overdraft
How to calculate the current ratio?
The current ratio is a financial ratio that is calculated by dividing current assets by current liabilities.
Current Ratio = (Current Assets / Current Liabilities)
Assume, it is an ABC company. Here is some information about ABC company.
The balance sheet for company ABC year ended on 31 March 2019
Particular | Amount |
---|---|
Non-current assets | |
Fixed assets | 425,000 |
Long term investments | 390,000 |
Total non-current assets | 815,000 |
Current assets | |
Cash in hand | 20,000 |
Bills receivable | 50,000 |
Inventory | 250,000 |
Prepaid expenses | 100,000 |
Short term loans | 200,000 |
Total current assets | 620,000 |
Total assets | 14,35,000 |
Equity | |
Share capital | 600,000 |
Reserve | 330,000 |
Total equity | 930,000 |
Non-current liabilities | |
Debentures | 200,000 |
Long-term loans | 150,000 |
Total non-current liabilities | 350,000 |
Current liabilities | |
Bills payable | 50,000 |
Overdraft | 100,000 |
Short-term loans | 5,000 |
Total current liabilities | 155,000 |
Total equity and liabilities | 14,35,000 |
Current Ratio = Current Assets/Current Liabilities
= 620000/155000 = 4 times
Ideally, a good current ratio should be around 2, which means the current assets should be twice the current liabilities.
The outcome of ABC company indicates that the company has 4 times more current assets than current liabilities. It implies that company ABC may not use its current assets appropriately.
What is the Quick Ratio?
The quick ratio is an indicator of the short term liquidity position of a company and measures a company's ability to pay its short term liabilities with the most liquid assets.
This ratio also indicates how quickly a company can utilise its short term assets to pay off short term liabilities. Hence, the quick ratio is also known as the acid test ratio as well.
How to calculate the Quick Ratio?
The quick ratio formula is given below,
Quick ratio = (current Assets - inventory - prepaid Expenses) / current Liabilities
Suppose it is an ABC company. Here is some information about the ABC company.
The balance sheet of ABC company as on 31.03.2019
Particular | Amount |
---|---|
Non-current assets | |
Fixed assets | 425,000 |
Long term investments | 390,000 |
Total non-current assets | 815,000 |
Current assets | |
Cash in hand | 20,000 |
Bills receivable | 50,000 |
Inventory | 250,000 |
Prepaid expenses | 100,000 |
Short term loans | 200,000 |
Total current assets | 620,000 |
Total assets | 14,35,000 |
Equity | |
Share capital | 600,000 |
Reserve | 330,000 |
Total equity | 930,000 |
Non-current liabilities | |
Debentures | 200,000 |
Long-term loans | 150,000 |
Total non-current liabilities | 350,000 |
Current liabilities | |
Bills payable | 50,000 |
Overdraft | 100,000 |
Short-term loans | 5,000 |
Total current liabilities | 155,000 |
Total equity and liabilities | 14,35,000 |
Quick Ratio = (6,20,000 - 2,50,000 - 1,00,000) / 1,55,000
Quick Ratio = 2,70,000 / 1,55,000
Quick Ratio = 1.74 times
The quick ratio of the ABC company is 1.74 which indicates that ABC company could pay off their current debts and obligations with quick assets and still have some quick assets remaining. This company reflects high liquidity.
A good quick ratio is 1 or more than 1, the greater number indicates enough liquid assets a company has to pay off its short term debts.
Current Ratio vs. Quick Ratio: What is the key difference between the current ratio and quick ratio?
The current ratio and quick ratio are liquidity ratios that measure the ability to meet current debt obligations with its short term assets but the quick ratio is more conservative because it does not include inventory and prepaid expenses. These assets are quietly less liquid assets.
Both ratios provide useful information about a company's liquidity. Sometimes the quick ratio may not give an exact figure because bills receivable are not easily collected from the customers.
The current ratio is considered all current assets of a company while the quick ratio is considered only those current assets which can be converted into cash within one year and the ideal current ratio is 2:1 whereas the ideal quick ratio is 1:1
Conclusion
Both the current ratio and quick ratio help you determine whether a company can easily pay off its current liabilities with its liquid assets.
A strong liquidity ratio of a company is always favourable for investors. It represents the good financial strength of a company. Hence these ratios play an important role in the fundamental analysis of a company.
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