Definition
The Current Ratio, also known as the liquidity ratio, measures a company’s ability to cover its short-term liabilities with its short-term assets. The Quick Ratio, also called the acid-test ratio, is similar but provides a more stringent assessment of a company’s short-term financial health by excluding inventory from current assets. In essence, it assesses a company’s capacity to use its ‘quick’ assets, such as cash and cash equivalents, to immediately offset its current liabilities.
Key Takeaways
- Current Ratio and Quick Ratio are both used to evaluate a company’s liquidity and its ability to meet short-term obligations. Simply put, they help us understand how well a company can cover its current liabilities with its current assets.
- While the Current Ratio considers all of the company’s current assets including cash, accounts receivable, and inventory, the Quick Ratio, also known as the acid-test ratio, only includes those assets that can be readily converted to cash such as marketable securities and accounts receivable. Inventory is excluded in the quick ratio, making it a more stringent measure of liquidity.
- The ideal ratio varies by industry, but generally, a Current Ratio above 1 indicates that the company can meet its short-term liabilities, whereas a Quick Ratio above 1 suggests the company can meet its immediate obligations without selling off its inventory. Thus, a lower quick ratio compared to the current ratio may indicate potential liquidity issues, especially if a big part of the company’s current assets is invested in slow-moving inventory.
Importance
The finance terms Current Ratio and Quick Ratio are both important liquidity measures used to determine a company’s ability to pay off its short-term liabilities with its short-term assets. The Current Ratio includes all current assets in its calculation, making it a broader measure of liquidity.
It shows how many times a company can cover its current liabilities using all of its short-term assets. On the other hand, the Quick Ratio, also known as the acid-test ratio, excludes inventory from its calculation because inventory can be difficult to quickly convert to cash.
Therefore, it provides a more stringent assessment of a company’s short-term liquidity. Both ratios are crucial for stakeholders such as investors, creditors, and suppliers in evaluating a company’s financial health and its efficient utilization of short-term assets.
Explanation
The current ratio and quick ratio are two important financial metric tools used by investors and analysts to evaluate a company’s short-term liquidity. Essentially, these ratios are utilized to gauge the ability of an organization to meet its short-term financial obligations or liabilities.
The current ratio measures a company’s capacity to pay off its current obligations by comparing its current assets to its current liabilities. The inclusion of all current assets in this ratio makes it a broad indicator of short-term liquidity, thereby giving a more generalized perspective of a company’s financial health.
On the other hand, the quick ratio, also known as the acid-test ratio, provides a more stringent evaluation of a company’s short-term liquidity position. Unlike the current ratio, the quick ratio only considers the most liquid current assets that can be quickly turned into cash, eliminating inventory and other less liquid assets from the equation.
Due to this, it gives a more conservative outlook, effectively highlighting the company’s ability to meet its immediate obligations using only its most liquid assets. Thus, while both ratios serve the same ultimate purpose, the quick ratio is a more specific and stringent measure of short-term financial well-being.
Examples of Current Ratio vs Quick Ratio
Apple Inc.: As per the financial statements of 2020, Apple’s current ratio is36, while its quick ratio isApple has a high current ratio indicating its ability to settle its short-term obligations. But, later we see that its quick ratio is lower. This happens because the quick ratio excludes inventory from current assets, and Apple has a considerable amount of its short-term assets in the form of unsold inventory.
Walmart: For Walmart, the current ratio is79 and quick ratio is18 in
The retailer’s current ratio is less than 1, which might raise eyebrows for some investors, signaling that the company might struggle to pay off its short-term liabilities. This situation gets worse when we look at the quick ratio, which excludes inventories – a significant part of Walmart’s current assets. This implies, without selling its inventory, the company might find it extremely difficult to meet its short term obligations.Microsoft Corporation: As per their 2020 annual report, Microsoft’s current ratio is53, and its quick ratio is
The current ratio indicates that Microsoft has more than enough current assets to cover its current liabilities. Also, there is not much difference between the current ratio and quick ratio, indicating that the company’s liquidity position would not vary much even if we exclude inventory and prepaid expenses. These three examples illustrate how the current ratio and quick ratio can give differing views on a company’s short-term financial health based on the composition of their current assets.
Frequently Asked Questions: Current Ratio vs Quick Ratio
1. What is the Current Ratio?
The Current Ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations. It is calculated by dividing a company’s Current Assets by its Current Liabilities.
2. What is the Quick Ratio?
The Quick Ratio, also known as the acid-test ratio, is a liquidity indicator that further refines the current ratio by measuring the level of the most liquid current assets available to cover current liabilities. It excludes inventory and other current assets, which are more difficult to liquidate. It is computed as (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities.
3. How do Current Ratio and Quick Ratio differ?
The main difference between the two lies in the assets they consider. The Current Ratio considers all current assets, while the Quick Ratio only includes the most liquid current assets. The Quick Ratio is therefore a stricter measure of liquidity.
4. Why are these ratios important?
These ratios are crucial for investors and creditors to assess the liquidity of a business. A higher ratio indicates higher liquidity, meaning the business is more able to meet its short-term obligations.
5. What is a good Current Ratio and Quick Ratio?
Generally, a good Current Ratio is 2.0, meaning the company has twice as many current assets as current liabilities. Meanwhile, a good Quick Ratio is usually 1.0, indicating that the company can pay off its short-term liabilities with its most liquid assets.
Related Entrepreneurship Terms
- Liquidity Ratios
- Current Assets
- Current Liabilities
- Inventory
- Short-term Solvency
Sources for More Information
- Investopedia: A comprehensive site offering a range of resources about various financial concepts including the Current Ratio and Quick Ratio.
- Corporate Finance Institute (CFI): A professional training and certification provider that also offers free resources on financial subjects.
- The Balance: This site provides expertly crafted financial information, covering a wide array of topics such as investment, saving, budgeting, and more.
- Accounting Tools: A site providing comprehensive resources on accounting and finance topics, including details on different financial ratios.
