Hello all, welcome to another podcast by Angel One!
As you may already know, investors use fundamental and technical analysis to determine the health and action of assets, as well as the financial performance of a company. Technical analysis includes the use of technical tools such as indicators and candlestick chart patterns. Fundamental analysis makes use of various formulae, ratios and calculations to understand the strength of a company. Liquidity ratios are one such aid and they play a very important role in fundamental analysis. A company with a ‘strong’ liquidity ratio is considered healthy and is favoured by investors.
Today, we will be discussing two types of liquidity ratios, see how they are calculated, and try to understand the difference between the two. The ratios in question are current ratio and quick ratio.
Let’s start with the current ratio- what is it?
The current ratio tells investors whether a company will be able to pay off its current liabilities using its current assets. These ‘current liabilities’ are basically all short-term debts of a company that are payable within a year. At the same time, all short term assets of a company that can be converted into money within a year, are known as ‘current assets’.
Let’s see how this ratio is determined.
The current ratio is basically all current assets of a company divided by all its current liabilities.
Ideally, the value of current ratio of a company should be greater than 1. A ratio that is less than one indicates that the company does not have enough assets to pay off all its liabilities if they were to fall due.
Coming to the quick ratio.
The quick ratio tells investors just how efficient a company is at paying off its current liabilities using its current assets.
That was confusing, wasn’t it? You see, while the quick ratio seems similar to the current ratio, it uses a slightly different method of calculation. The quick ratio only considers current assets that can be liquidated in less 90 days or less. It is also known as the acid-test ratio.
To determine the quick ratio, you’ll have to start by adding the value of cash + cash equivalents + current receivables + short-term investments of a company. Then, divide this number by the total amount of current liabilities.
Now preferably, the quick ratio of a company should be 1 or more. A ratio less than 1 tells us that the company is not capable of meeting its liabilities if they are all due at the same time.
Let’s go ahead and compare some of the key differences between the two. It will give us clarity about the concept and also help us see how they are used.
Compared to the quick ratio, the current ratio is a more relaxed approach that helps us determine a company’s ability to repay debt. The quick ratio can be considered more conservative and evidently more strict.
The current ratio is essentially used to calculate the proportion of a company’s current assets to its current liabilities. So it includes all current assets of the company in the formula. While the quick ratio considers only the company’s most liquid assets against all current liabilities. So it includes only those current assets of the company that can be liquidated in less than 90 days.
Are you now getting the hang of it? Let’s go on.
The interesting thing about the current ratio is that it takes into consideration the inventory stock of a company. The quick ratio effectively excludes the inventories. What this means is that if a company maintains a strong inventory, its current ratio is likely to be naturally high. Conversely, the quick ratio of such a company will naturally be low. This means that the difference between the values of the two ratios can somewhat indicate the strength of the assets and inventory for a single company.
For this reason, a current ratio should ideally be higher than the quick ratio. While a current ratio of more than 1 is ideal, 2:1 is more preferable. A quick ratio of 1:1 works well.
Hopefully that makes the distinction crystal clear!
Instead of trying to decide what ratio you should consider, you can use both of them. Like with any tools for analysis in trading, these ratios should be used in conjunction with each other. They can be used to determine the levels of liquidity of companies.
Find more resources about tools for fundamental and technical analysis at www.angelone.in.
As usual, happy investing!