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The current ratio and quick ratio are used to analyze the liquidity of a company within a specified period, but they both approach it differently. The key difference between the two ratios lies in the assets used in each calculation. This makes each ratio useful for analyzing different aspects of a company’s position to meet short-term obligations.
The article explains the meaning and differences between the two ratios and their importance in financial analysis.
Key Takeaways
- The current ratio compares current assets with current liabilities to assess short-term liquidity.
- The quick ratio compares quick assets with current liabilities after excluding inventory and prepaid expenses.
- Since the ratios use different formulas, they can produce different results for the same company.
- Both ratios show whether a company's liquidity depends heavily on inventory sales.
- Cash flow, industry conditions, and asset quality should also be considered alongside liquidity ratios.
What is the Current Ratio?
The current ratio, or working capital ratio, assesses a company's ability to pay its short-term liabilities within a year using its current assets.
It compares a company's total current assets to total current liabilities and is calculated as:
Current Ratio = Current Assets ÷ Current Liabilities
Traditionally, a current ratio of 2:1 is considered a benchmark. It is not a fixed standard for every company or industry. The right level can differ based on the nature of the business.
Current Ratio Calculation Example
| Particulars | Amount (₹) |
| Current Liabilities: | |
| Trade Payables | 2,50,000 |
| Short-Term Borrowings | 1,50,000 |
| Outstanding Expenses | 1,00,000 |
| Total | 5,00,000 |
| Current Assets: | |
| Cash and Cash Equivalents | 2,00,000 |
| Trade Receivables | 3,00,000 |
| Inventory | 4,00,000 |
| Short-Term Investments | 1,00,000 |
| Total | 10,00,000 |
Applying the current ratio formula,
Current Ratio = 10,00,000/5,00,000
= 2 or 2:1
This means the company has ₹2 in current assets for every ₹1 of current liabilities.
What is the Quick Ratio?
The quick ratio measures a company's ability to cover short-term liabilities with assets that can be easily used or converted into cash.
It is also known as the acid-test ratio. It compares the quick assets of a company with its current liabilities and is calculated as -
Quick Ratio = Quick Assets ÷ Current Liabilities
Unlike the current ratio, inventory and prepaid expenses are not included in quick assets. This is because inventory may take time to sell, while prepaid expenses cannot be used to settle liabilities.
In a traditional context, 1:1 is considered a standard level for the quick ratio. It may vary across industries, depending on the nature of the business and its ability to generate or collect cash.
Quick Ratio Calculation Example
Let us continue with the same example of RTY Ltd. to understand the quick ratio.
To get quick assets:
Quick Assets = Total Current Assets − Inventory
= ₹10,00,000 − ₹4,00,000
= ₹6,00,000
Now, applying the quick ratio formula:
= ₹6,00,000 ÷ ₹5,00,000
= 1.2 or 1.2:1
This shows the company has ₹1.20 in quick assets for every ₹1 of current liabilities.
Current Ratio vs Quick Ratio: Key Differences
The following table shows the key differences between the current ratio and the quick ratio:
| Basis | Current Ratio | Quick Ratio |
| What it measures | A company's ability to pay its short-term liabilities using all current assets. | The ability of a company to pay its short-term liabilities using only its quick assets. |
| Assets included | Total current assets, such as cash, inventory, and receivables. | Cash and cash equivalents, trade receivables and short-term investments. |
| Inventory | Inventory is included in the calculation. | Inventory is deducted when calculating quick assets. |
| Prepaid expenses | It is included as part of current assets. | It is excluded because it cannot be used to pay liabilities. |
| Liquidity assessment | This provides a wider view of the company's short-term financial position. | This provides a stricter measure by focusing on assets that are more readily available to meet liabilities. |
| Formula | Current Assets/Current Liabilities | Quick Assets/Current Liabilities |
| Also known as | Working capital ratio | Acid test ratio |
Why the Difference Matters
The two ratios follow different calculation processes because all the current assets are not equally useful for paying short-term liabilities immediately.
Inventory is a current asset, but it may take time to convert into cash. For instance, a retail shop owner may hold unsold stock for several months, and a manufacturer might hold raw materials that first need to be processed into finished goods and then sold.
Similarly, prepaid expenses cannot be converted into cash or used to pay a liability because they have already been paid.
This is why the quick ratio excludes inventory and prepaid expenses. The purpose is to check how well a company can meet its short-term liabilities without depending on the sale of inventory or other assets that cannot be readily used as cash.
Also Read About: Liquidity Ratio
Other Ratios to Consider
Analysing the following ratios along with the current ratio and quick ratio can provide further information about a company's financial position:
- Cash Ratio: This measures whether a company can pay its current liabilities using only cash and cash equivalents. This is an even stricter ratio compared to the current and quick ratios.
Considering the above balance sheet figures of RTY Ltd, the cash ratio can be calculated as:
Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities
= ₹2,00,000 ÷ ₹5,00,000
= 0.4 or 0.4:1
- Operating Cash Flow Ratio: It compares the cash generated from operating activities against current liabilities. The ratio shows whether the company's regular business operations generate enough cash to meet short-term obligations.
Let us assume RTY Ltd. has cash flow from operating activities of ₹6,00,000,
Operating Cash Flow Ratio = Cash Flow from Operating Activities ÷ Current Liabilities
= ₹6,00,000 ÷ ₹5,00,000
= 1.2 or 1.2:1
- Interest Coverage Ratio: This ratio shows whether a company earns enough to pay interest on its borrowings. A higher ratio means the company earns more relative to its interest payments.
Suppose the company reports an Earnings Before Interest and Taxes (EBIT) of ₹12,00,000 and interest expenses of ₹2,00,000. The ratio is:
Interest Coverage Ratio = EBIT ÷ Interest Expense
= ₹12,00,000 ÷ ₹2,00,000
= 6 times
- Debt-to-Equity Ratio: The ratio shows the relationship between a company's total debt and shareholders' equity. It measures how much a company is dependent on borrowed funds compared with its equity.
Now, consider that the company has a total debt of ₹15,00,000 and shareholders' equity of ₹30,00,000. Therefore, the ratio is calculated as,
Debt-to-Equity Ratio = Total Debt ÷ Shareholders' Equity
= ₹15,00,000 ÷ ₹30,00,000
= 0.5 or 0.5:1
Conclusion
The current ratio and quick ratio are useful starting points for assessing a company's short-term financial position. To draw a more meaningful conclusion, examine them alongside the company's past ratios, industry levels, cash flows, and the quality of its assets. This helps investors and analysts assess liquidity in the context of the company's overall financial position.
Also Read About: Ratio Analysis
