Current ratio vs. quick ratio: understanding liquidity in financial analysis

Liquidity ratios are essential tools in financial analysis, offering insight into a company’s ability to meet its short-term obligations.

Two of the most widely used liquidity ratios are the current ratio and the quick ratio. Understanding the differences between these two ratios is key to evaluating a company’s financial health and liquidity.

Current ratio

The current ratio measures a company’s ability to pay off its short-term liabilities with its current assets.

Formula

Current ratio calculation

Components:

  • Current assets: Assets expected to be converted into cash or used within one year, such as cash, accounts receivable, inventory, and prepaid expenses.
  • Current liabilities: Obligations the company must pay within one year, including accounts payable, short-term loans, and accrued expenses.

Interpretation:

  • A current ratio greater than 1 suggests the company has more current assets than liabilities, indicating a good liquidity position.
  • A ratio less than 1 implies the company may struggle to meet its short-term obligations, signalling potential liquidity issues.

Limitations:

  • The current ratio includes all current assets, even those that may not be easily liquidated, such as inventory and prepaid expenses, potentially overstating a company’s liquidity.

Quick ratio

Also known as the acid-test ratio, the quick ratio offers a stricter measure of a company’s liquidity by excluding less liquid assets.

Formula

Current ratio calculation example

Components:

  • Quick assets: Current assets that can be quickly converted into cash, such as cash, cash equivalents, marketable securities, and accounts receivable. Inventory and prepaid expenses are excluded.
  • Current liabilities: As defined above.

Interpretation:

  • A quick ratio greater than 1 means the company has sufficient liquid assets to cover its short-term liabilities without relying on selling inventory.
  • A ratio less than 1 suggests the company may face difficulties in meeting its short-term obligations due to a lack of liquid assets.

Limitations:

  • The quick ratio is a more conservative measure and may not reflect the company’s actual liquidity, particularly if it has significant inventory or prepaid expenses that could be converted into cash.

By excluding inventory, the quick ratio provides a more conservative assessment of a company’s ability to meet short-term liabilities. It reflects the company’s immediate liquidity without relying on slow-moving inventory. Generally, a quick ratio of 1 or higher is considered satisfactory, indicating that a company can swiftly settle its obligations without relying on inventory liquidation.

While both ratios assess a company’s liquidity, they approach it from different perspectives. The current ratio considers all current assets, including inventory, while the quick ratio excludes it. By doing so, the quick ratio aims to be more conservative by focusing solely on highly liquid assets like cash, marketable securities, and accounts receivable.

The inclusion of inventory in the current ratio can distort the overall liquidity position. Some industries with slower inventory turnover may have large amounts tied up in inventory, which can inflate the current ratio. However, this does not always reflect the true liquidity of the company.

Both ratios are important in evaluating a company’s liquidity position, but their interpretation may vary depending on the industry and business model.

For industries where inventory turnover is rapid, such as retail or manufacturing, the current ratio may provide a more accurate reflection of liquidity. It considers the company’s investment in inventory, which is necessary for operations. In comparison, the quick ratio may undervalue their ability to meet short-term obligations.

However, in industries where inventory liquidity is slower, such as real estate or automobile manufacturing, the quick ratio offers a better measure of short-term liquidity. These sectors often require substantial investments in inventory and excluding it from the quick ratio ensures a more realistic assessment.

Understanding the industry context and a company’s business model is crucial when determining which ratio is more relevant for financial analysis. By considering both ratios, analysts can get a comprehensive understanding of a company’s overall liquidity and make more informed decisions.

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Steve Carlsson, Trade Radar
Written by Steve Carlsson Founder & Director
13 Jan 2025

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