Fundamental analysis is a great way for investors to gauge the financial performance of a company before investing in it. It utilizes several formulas, ratios, and calculations to determine the overall fundamental strength of a company. Among the various techniques used by investors, liquidity ratios play a pivotal role when it comes to fundamental analysis.
Liquidity ratios such as the current ratio and the quick ratio help you determine whether a company is capable of meeting its debt obligations when it becomes due. A company with a strong liquidity ratio is always favoured by investors, since they showcase the financial strength of the entity. Let’s take an indepth look at these two ratios, the formula that’s used to calculate them, and the difference between current ratio and quick ratio.
What is the current ratio?
The current ratio is a liquidity ratio that’s used by investors to determine whether a company is capable of paying off all of its current liabilities using its current assets. All the short-term debts of a company that are payable within a year are tagged under ‘current liabilities’. Meanwhile, all of the short-term assets of a company that can be easily converted to cash within a year are tagged under ‘current assets.’
Now that you know what the current ratio is, let’s take a look at the formula used to determine this ratio.
Current ratio = current assets ÷ current liabilities
Ideally, the current ratio of a company should be more than 1. Anything that’s less than 1 would mean that the company lacks the necessary assets to pay off all of its liabilities if they ever fall due.
What is the quick ratio?
The quick ratio, on the other hand, is another liquidity ratio that’s typically used by investors to determine how efficient a company is at paying off all of its current liabilities using its current assets. While it might look similar to the current ratio, the quick ratio is a more conservative method of calculation since it takes into consideration only those current assets that can be liquidated in less than 90 days. The quick ratio is also known as the acid-test ratio.
Let’s now take a look at the formula that’s used to determine the quick ratio.
Quick ratio = (cash + cash equivalents + current receivables + short-term investments) ÷ current liabilities
Preferably, the quick ratio of a company should also be more than 1. A ratio less than 1 effectively means that the company is not capable of meeting its liabilities if they all fall due at the same time.
Now that you’ve understood both these ratios, you probably have the question ‘what is the difference between quick ratio and current ratio?’ in your mind. Here’s the answer to it.
What is the difference between quick ratio and current ratio?
With respect to the current ratio vs quick ratio debate, listed below are some of the key differences that you should know.
|The current ratio is a more relaxed approach towards determining a company’s debt repaying ability.
|The quick ratio is a more stringent and conservative approach that’s used to determine a company’s debt repaying ability.
|This ratio is used to calculate the proportion of a company’s current assets to its current liabilities.
|This ratio is used to calculate the proportion of a company’s highly liquid assets to its current liabilities.
|This ratio includes all of the current assets of the company.
|This ratio includes only those current assets of the company that can be liquidated to cash in less than 90 days.
|The current ratio also includes the inventory stock of a company.
|The quick ratio excludes the inventories of a company.
|While anything that’s more than 1 is ideal, a current ratio of 2:1 is preferable.
|A quick ratio of 1:1 is preferable.
|The current ratio is likely to be naturally high for companies that have a strong stock of inventory.
|The quick ratio is likely to be naturally low for companies with a strong stock of inventory.
Although these two ratios may appear quite similar to each other at first glance, the difference between current ratio and quick ratio is quite clear and abundant. That said, instead of getting into the current ratio vs quick ratio dilemma, as an investor, it would be a better idea to use both of these ratios in conjunction with each other to determine the level of liquidity that a company possesses.