We have realised, time and again, how assets run as the criterion for the successful evaluation of a business. But, accurately quantifying the financial health of a firm is not a cakewalk. For this, one needs to consider various parameters of fundamental analysis but especially the firm’s liquidity, i.e., Current Ratio and Quick Ratio.
But. What is liquidity?!
Well. It is the pace at which a company can encash its assets.
Let us suppose that things start drifting south suddenly, and all bills are due now. So, does the company have enough resources to encash immediately and resolve the situation?
This question is a vital concern of investors.
Irrespective of profitability, non-liquidity is always a big red flag for an organisation. Luckily enough, spotting these red flags is not some quantum physics. The most popular method for measuring liquidity is using financial ratios, or should we say, liquidity ratios, to be more precise.
The Current Ratio and the Quick Ratio play a pivotal role in the smooth execution of operations in a firm. Curious about the know-how?
Read on. We have it all covered.
The Current Ratio and Quick Ratio are the crowning glories of financial analysis. They are strong indicators of the cash availability in a company. The ratios are perfect for ascertaining the short-term financial health of a company.
A higher value of these ratios indicates stability in the financial position, whereas low numbers might signal financial hardships.
Now, these ratios are also a token of efficiency. They explain how fast-paced conversion can a company execute from inventories into cash. It tells you the efficiency of operations of the firm in the market. Keeping in mind the motives of the creditors, we can say that liquidity ratios make it easy to determine the creditworthiness of a company. It is, in turn, helpful in offering short-term debts.
The ratios are also a great tool to streamline the working capital requirements of a company. It gives you valuable insights into the operating cycle of the firm. Knowing these insights helps you study the levels of cash and liquid assets at a certain period. Hence, it helps you plan your investments efficiently eventually.
In a nutshell, Current and Quick Ratios are vital for knowing how much money is readily available in the company. It tells you the number of liabilities that a company can pay immediately. So, the main question is, how are these ratios capable of doing that?
To answer this question, we need to dive into the details of Current and Quick Ratios. Hence, without any further ado, let us dive right in.
So, what exactly are these ratios?
Let us dissect both the ratios for you step by step.
Definition.
The Current Ratio is the ratio of cash and assets due within a year to the liabilities that require clearance within a year.
Formula.
The experts calculate this ratio by comparison of the current assets of a company with its current liabilities.
Hence, the formula for calculating current assets is
CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES.
As listed above, two vital components of the formula are current assets and current liabilities.
Current assets include cash and cash equivalents, trade receivables, prepaid expenses, marketable securities, and Inventories.
Current liabilities include short-term debt (payable within 12 months), outstanding liabilities, trade payables, and other current liabilities.
When a company calculates the Current Ratio just after receiving payment from its debtors, this leads to a high Current Ratio.
Similarly, when the company calculates the Current Ratio after making payments to creditors, this leads to a low Current Ratio.
Manga collections have current assets worth INR 3,00,000 and current liabilities worth INR 1,60,000. Let us calculate the Current Ratio for Manga collections with its formula.
Given,
Current Assets = 3,00,000
Current liabilities = 1,60,000
We know that,
Current Ratio = Current Assets / Current liabilities
Current Ratio = 1,50,000 / 80,000
Current Ratio = 1.875
Interpretation –
A Current Ratio of 1.875 indicates the company can pay its obligations 1.875 times more than its actual value.
A Quick Ratio, otherwise called the Acid Test or Liquid Ratio, is a ratio that measures how a company could pay off its liabilities without requiring an additional loan or financial help from major lenders or without having to sell off its assets.
An asset is said to be liquid if it can be converted into cash in a short period of time without considerable loss of value.
The vital difference between the Current and Quick Ratio is current assets and liabilities compared to quick assets and liabilities. It determines how liquid your assets and liabilities are and how easily you can convert them into cash.
The easier it is for the firm to convert assets into cash, the higher the ratio, and the company is less likely to suffer and vice versa.
There are many ways to calculate Quick Ratio (QR).
One of the formulas is by summing up Cash and Equivalents (CE), Marketable Securities (MS), and Account Receivables (AR) and dividing them by Current Liabilities (CL).
The formula is:
Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivables)/ Current Liabilities.
In another formula, we deduct prepaid expenses and inventories from the current assets and bank overdrafts from the current liabilities.
The formula is:
Quick Ratio= Current assets – (Inventories + Prepaid Expenses)/ Current Liabilities – Bank Overdraft.
The numerator of the formula should include assets that are easy to encash within 90 days or less.
The two main components included in the Quick Ratio are Liquid assets or quick assets and current liabilities.
Liquid Assets include cash in hand, cash at the bank, bills receivables, Sundry debtors, and Marketable Securities.
Liquid Assets are ones you can convert into cash as soon as possible, and while doing so, the company does not incur higher costs, and there should be minimal to no loss in value.
Current Liabilities include outstanding expenses, bills payable, sundry creditors, to-be-paid income tax, and dividends payable.
A company’s short-term obligation becomes due in the next year and is present on the balance sheet.
Suppose a company named Doodle has following data:
Bank loan = 1,00,000
Stock in Trade = 1,35,000
Sundry Creditors = 1,50,000
Sundry Debtors = 70,000
Bills payable = 20,000
Cash in Hand and Cash at Bank = 15,000 + 1,10,000
Then, how do you calculate its Quick Ratio?
We know that,
Quick Ratio = Quick Assets/Current Liabilities.
Now,
The calculation of quick assets includes summing Cash in Hand and at Bank and Sundry Debtors. The calculation for the following are:
1,25,000 + 70,000 = 1,95,000
Similarly, the calculation for current liabilities includes summing Sundry Creditors and Bills Payable. The calculation for the following are:
1,50,000 + 20,000 = 1, 70,000
So, the Quick Ratio would be = 1,95,000/1,70,000 = 1.14.
Interpretation –
This ratio indicates that company Y can pay its obligation 1.14 times its actual value.
The ideal Current Ratio is 2:1. Now, we know that the Current Ratio denotes the ability of a firm to pay its short-term obligations.
So, a Current Ratio below 1 signifies that the firm does not have enough liquid assets to meet its short-term obligations if all of them are due at once.
But, a Current Ratio above 1 signifies that the firm can resolve its insolvency in the short term.
However, one should not view the Current Ratio as a whole picture. Because it only provides short-term synopsis of the financial health of a company.
So, even if the firm has an ideal Current Ratio, a few factors can be deceiving. Like,
The ideal Quick Ratio is 1:1. This result of 1:1 suggests that the company has enough assets to pay its short-term obligations. The current assets used in the Quick Ratio are the ones that can be liquidated within a day or two.
A company with a Quick Ratio value below one might fall short of paying its short-term debts fully. But, a Quick Ratio above one signifies a company that can immediately pay its short-term debt.
Similar to the Current Ratio, the Quick Ratio offers a synopsis of short-term financial health but fails to represent the whole picture of a company.
It is vital to take into consideration other financial ratios to have a full-fledged assessment of the financial position of an organisation.
The ultimate difference between the Current Ratio and Quick Ratio is the difference in measuring a firm’s liquidity.
The Quick Ratio appears to be all buttoned up with its methodology. It does not include inventory and other assets that cannot be turned into cash instantly. The Quick Ratio is strict in terms of liquidity measurement of an organisation.
Both Current Ratio and Quick Ratio include receivables during their measurement. However, not all receivables are quickly liquidated. So, they both might misrepresent to a certain extent. But, the Quick Ratio is less flawed than the Current Ratio.
An all-encompassing comparison chart between the Current Ratio and Quick Ratio would be perfect to deliver a quick overview of the topic.
So, here we go.
BASIS | CURRENT RATIO | QUICK RATIO |
Definition | The Current Ratio is the ratio that states the proportion of current assets to current liabilities. | A Quick Ratio is a ratio between liquid current assets and current liabilities. |
Synonymous names | The Current Ratio is also known as the working capital ratio. | The Quick Ratio is also known as the acid test ratio. |
Purpose | The Current Ratio helps understand the ability of the firm to take care of its current obligations. | The Quick Ratio helps understand if the firm can take care of urgent requirements when they come up in the future. |
Includes | The Current Ratio includes all current assets and liabilities. | Quick Ratio includes current assets except for the inventory and the prepaid expenses and liabilities except for bank overdraft. |
Optimum Ratio | A Current Ratio of 2:1 is preferred. | A Quick Ratio of 1:1 is preferred. |
Nature | It is liberal when it comes to measuring liquidity. | It is strict in terms of liquidity measurement. |
Appropriate | It is appropriate for all types of firms and businesses. | The Quick Ratio is appropriate for a firm with highly valued inventories. |
Companies with an industrial background that requires stocking up the inventories for a season before selling them have a higher Current Ratio. Inventory stock is higher in the peak season but ebbs as the season passes away.
So, if a company measures its Current Ratio in the peak season, it can show a higher value. But, the off-season calculation may degrade the amount completely.
Therefore, the Current Ratio may fluctuate heavily for such companies.
However, removing inventory and calculating the Quick Ratio might also deceive you from the true picture. Companies with an industrial background in selling inventory that sells quickly might face low value in Quick Ratio. But, in reality, their inventories are as good as any other quick asset.
So, the efficacy of the Current Ratio and Quick Ratio is subjective to the type of industry of a business.
Conclusion
The liquidity ratios are vital in understanding the short-term financial health of a firm. But, one ratio can never represent its overall financial position. It is necessary to consider several financial ratios to critically ascertain the accurate report of the financial status of an organisation.
Once you start understanding what each ratio is trying to tell you, no company can deceive you about its financials.
Yes! Apart from the Current Ratio and Quick Ratio, there are two more. One is the Cash Ratio, and the other is the Operating Cash Flow Ratio.
The Cash Ratio is a proportion that determines the ability of the company to resolve its short-term liabilities only with its stack of cash and cash equivalents.
It is also called the cash asset ratio. It aims at helping an investor understand the capabilities of a business in fulfilling its current liabilities, usually those that have a tenure of 12 months or less, with the help of cash and cash equivalents.
The formula for this ratio is:
CASH RATIO = CASH AND CASH EQUIVALENTS/SHORT-TERM LIABILITIES.
A higher value of this ratio signifies ample liquidity and vice-versa.
The Operating Cash Flow Ratio is the proportion that determines the ability of a business to resolve its current liabilities with the help of cash flow generated only from its main business operation.
This ratio is timeframe and activity-specific and tells the liquidity of a business at a particular time due to a specific activity. It also includes accruals to give a clear picture of the short-term liquidity of an organisation.
The formula for this ratio is:
OPERATING CASH FLOW RATIO = CASH FLOW FROM OPERATIONS/CURRENT LIABILITIES.
A higher value signifies better liquidation capabilities and vice versa.
You can find out the cash flow from operations in the cash flow statement of a company.
However, you can also calculate it by finding out the business's net income and then adding non-cash expenses (for example - depreciation) and working capital changes.
It isn't very likely. The ideal Current Ratio is 2:1, and the excellent value for the Quick Ratio is 1:1. The Current Ratio includes each current asset, while the Quick Ratio comprises only cash and cash equivalents, marketable securities, and account receivables.
For the Current Ratio and Quick Ratio to be the same, an organisation's inventories and prepaid expenses must be nil, and there must be no bank overdraft.
Even if other things are in place, the absence of inventories seems like an unimaginable situation for an organisation. Hence, it is not ideal for a company to have the same Current Ratio and Quick Ratio. Ideally, the Current Ratio is approximately double the Quick Ratio.
We all know how crucial the Quick Ratio is as an indicator for a financially stable company. A healthy Quick Ratio is sure to put you in the investors' good books. There are three ways to manage the health of your Quick Ratio, and they are:
We are well aware of the deceiving nature of inventories. Counting inventories as a plus point towards assessing a firm's liquidity can be a mistake. There might be dead stock in the name of inventories, and these stocks have no value. Hence, the inclusion of such stocks can give you a deceiving picture of an organisation.
This situation is where the Quick Ratio came into view. The exclusion of inventories from the Quick Ratio propels the investors towards a clearer picture of the firm. However, there might be a deceiving element in the Quick Ratio too.
Account receivables. The calculation of both Quick Ratio and Current Ratio includes account receivables. However, they may not be genuinely liquid, as they may comprise long-term debtors or potential bad debts which cannot be turned into cash when necessary. Hence, putting the firm in a difficult position. This element might be a limitation of the Current Ratio and Quick Ratio.
Please note that by submitting the above mentioned details, you are authorizing TradeSmart to call and email you and also to send promotional communication even though the contact number may be registered under DND.
Please note that by submitting the above mentioned details, you are authorizing TradeSmart to call and email you and also to send promotional communication even though the contact number may be registered under DND.
Open Demat Account &
Trade @ Rs15 per order.
“Filing of complaints on SCORES – Easy & quick”
Please note that by submitting the above mentioned details, you are authorizing TradeSmart to call and email you and also to send promotional communication even though the contact number may be registered under DND.