Current Ratio and Quick Ratio: Assessing Short-term Liquidity

Ravi had delved into profitability metrics, but he realised that profitability alone didn’t give the full picture of a company's financial health. He needed to understand a company’s capacity to meet short-term obligations. After all, a profitable company that can’t pay its bills on time faces serious challenges. To evaluate this, Ravi turned to two important liquidity ratios- Current Ratio and Quick Ratio. These ratios would provide him with insights into a company's ability to manage short-term liabilities, offering a more rounded view of its financial position.

Quick Ratio vs. Current Ratio: An Overview

Both the current and quick ratios measure a company’s short-term liquidity, i.e., its ability to cover upcoming debts. However, they differ in approach:

• Current Ratio includes all assets that can be converted to cash within a year.
• Quick Ratio, or acid-test ratio, only includes assets that can be quickly converted to cash (within 90 days), excluding inventory and other less-liquid assets. This makes the quick ratio a more conservative measure of liquidity.

Current Ratio Explained

The current ratio shows a company's ability to pay its short-term liabilities using its current assets. It’s calculated as follows:
Current Ratio = Current Assets / Current Liabilities

• Current Assets include cash, marketable securities, accounts receivable, prepaid expenses, and inventory.
• Current Liabilities include short-term debts, accounts payable, and other liabilities due within a year.
  Example: A company with ₹20 lakh in current assets and ₹10 lakh in current liabilities has a current ratio of:
  Current Ratio=20,00,000/10,00,000=2

A ratio of 2.0 suggests that the company has twice as many current assets as liabilities, indicating a strong liquidity position.

Interpreting the Current Ratio

• Greater than 1.0: Generally a positive sign, suggesting the company can cover its short-term debts.
• Less than 1.0: A potential red flag, indicating that the company may struggle to meet short-term obligations.

While the current ratio provides an overall view, it can sometimes overstate liquidity if a large portion of current assets is tied up in inventory or assets that aren’t easily liquidated.

Quick Ratio Explained

The quick ratio is a stricter measure of liquidity than the current ratio, as it focuses only on the most liquid assets:
Quick Ratio = (Cash + Cash Equivalents + Current Receivables + Short-term Investments) / Current Liabilities
Alternatively, you can calculate it by subtracting inventory and prepaid expenses from current assets and then dividing by current liabilities.
Example: For the same company, with ₹10 lakh in cash, ₹5 lakh in accounts receivable, and ₹5 lakh in inventory:
Quick Ratio = (10,00,000 + 5,00,000) ÷ 10,00,000 = 1.5
A quick ratio of 1.5 indicates that the company has enough liquid assets to cover its short-term liabilities without relying on inventory sales.

Key Differences between Quick Ratio and Current Ratio

• Conservativeness: The quick ratio excludes inventory and prepaid expenses, offering a stricter liquidity measure.
• Inclusion of Inventory: The current ratio includes inventory and prepaid expenses, which can overstate liquidity in industries with less-liquid assets.
• Industry Relevance: Industries with high inventory, like retail, may have a higher current ratio but a lower quick ratio, making the quick ratio more accurate for assessing liquidity in such cases.

When should you use each Ratio?

• Quick Ratio: More useful in assessing immediate liquidity, especially for industries with fast-changing demand or inventory obsolescence risk.
• Current Ratio: Suitable when immediate liquidity isn’t an issue, and the company can manage its liabilities comfortably over the year.

Limitations of Current Ratio and Quick Ratio

• Quick Ratio: Excluding inventory can undervalue liquidity in sectors with rapid inventory turnover, such as supermarkets.
• Current Ratio: Including inventory may overstate liquidity, particularly in industries where inventory takes time to sell.

Conclusion

With a solid understanding of the current and quick ratios, Ravi now had essential tools to assess a company’s ability to meet its short-term liabilities. The current ratio offers a broad view of liquidity, while the quick ratio provides a more conservative assessment by focusing on the most liquid assets. In the next chapter, Ravi will explore the Debt-Equity Ratio to gain insights into a company's long-term financial stability.