Current Ratio vs Quick Ratio - key differences

While the current ratio considers all current assets like inventories and prepaid expenses, the quick ratio looks at those assets that can be converted into cash quickly. It is possible to gauge an organization's capacity to meet its current liability obligations by calculating its current and quick ratios.

The current ratio, also known as the working capital ratio, measures a company's liquidity and ability to meet its short-term obligations. Divide your short-term debt by your short-term assets to get your current ratio. Everything that can be counted in the current fiscal year includes prepaid costs, inventories, cash, and cash equivalents. Whereas the quick ratio does not factor in inventory or prepaid expenses. It considers only highly liquid monetary assets or those that can be changed into cash quickly and easily.

Factors affecting the Current Ratio

The current ratio is the measure of a company’s ability to meet current (or short-term) liabilities (debt and payables) with current (or short-term) assets. A company's assets that can be converted into cash within a year are considered current assets. The company's debts and other commitments that appear on the balance sheet and are due within a year are considered current liabilities.

Factors affecting the Quick Ratio

The quick ratio assesses a company's liquidity by looking at how easily its current assets can pay off its current liabilities. Compared to the current ratio, the quick ratio is a more cautious indicator of liquidity because it excludes some. Still, not all components are used to calculate the current ratio. For the quick ratio, also known as the acid-test ratio, only assets having a maturity of 90 days or less or a shorter time frame are considered.

Key differences between Current Ratio and Quick Ratio 

The quick ratio highlights a company's liquid assets while ignoring inventory and other illiquid assets. Because the quick ratio excludes inventories and other difficult-to-liquidate current assets, it provides a more cautious picture of a company's liquidity or capacity to satisfy its short-term commitments with its short-term investments (i.e., turn into cash).

Accounts receivable are factored into both measures, but they may take longer than expected to collect. Because of this, if receivables are challenging to manage and convert to cash, even the quick ratio may not accurately reflect liquidity.

Special Considerations

You should know about the current and quick ratio's special considerations. Companies that deal in stock will have a high current ratio because of the inclusion of inventory in the calculation. To improve its current ratio, a retailer, for instance, can buy extra inventory in the weeks before the holidays. The ratio, however, would drop significantly once the season ended. Therefore, the current ratio for stores and similar businesses would change over the year.

However, for some sectors, the picture of liquidity painted by clearing off inventory may not be accurate. Supermarkets, for instance, have high inventory turnover rates; therefore, the stock is probably a significant part of their current assets. If supermarkets' inventory were depleted, their quick ratio would look worse since their current liabilities would be higher than their current assets.

Calculation -- current ratio vs quick ratio:

To calculate a company's current ratio, divide its current assets by its current liabilities using the formula below.

Current Ratio = Current Liabilities / Current Assets

The current ratio indicates the extent to which an organization's short-term assets cover its short-term obligations. Investors would be wary of the company since it would have trouble meeting its short-term debt obligations.

Companies with a current ratio greater than one are safer bets since they can more readily meet their short-term obligations with the cash on hand.

Cash, marketable securities, and accounts receivable are added together and then divided by current liabilities to arrive at the quick ratio.

Quick Ratio = (Cash + Cash Equivalents + Current Receivables + Short-Term Investments) / Current Liabilities

The quick ratio can be determined even if the fast assets of a corporation are not broken out in the financial statements. It is possible to calculate working capital by dividing current assets by current liabilities after deducting inventory and prepaid assets from existing assets.

Like the current ratio, a quick ratio above one indicates that the company is in better financial shape than one with a quick ratio below that level.

Conclusion

There is no universally applicable measure for assessing a firm's liquidity. The current, quick, and other financial ratios should all be factored into your research. Moreover, it is crucial to know what aspects of a company's financials the ratios exclude or include to grasp the information provided by the ratio fully.

FAQs

Q. What exactly is the quick ratio, and how is it used?

The quick ratio is a valuable metric for discerning if a company has the liquid assets necessary to meet its short-term debt commitments. Aside from this distinction, the quick ratio is identical to the current ratio. During the quick ratio calculation, all liquid assets besides inventories are considered.

Q. When the current ratio is more than 1, what does that indicate?

If a company's current ratio exceeds 1, its assets can be quickly converted into cash and used to settle its short-term debts. 

Q. What makes the quick ratio more prudent than the current ratio?

Because of the fewer items used in its calculation, the quick ratio is more cautious than the current ratio.