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Both current ratio and quick ratio are important tools used to measure a company’s short-term financial health. They show how well a business can meet its current obligations using available assets. While the current ratio takes into account all current assets, the quick ratio is more conservative as it excludes inventory and prepaid expenses. Together, these ratios help investors, creditors, and managers evaluate liquidity risk.
The current ratio measures a company’s ability to pay off its short-term liabilities with its short-term assets. It shows whether the firm has enough resources to cover debts due within a year.
Formula:
Current Ratio = Current Assets ÷ Current Liabilities
A higher ratio generally indicates higher liquidity, while a lower ratio could suggest challenges in meeting obligations. However, very high ratios may also signal underutilised assets.
The quick ratio, also called the acid-test ratio, evaluates liquidity by excluding less liquid current assets such as inventory and prepaid expenses. It provides a stricter measure of a company’s ability to meet short-term obligations without relying on stock sales.
Formula:
Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) ÷ Current Liabilities
It is particularly useful in industries where inventory may take longer to convert into cash.
Current Ratio = Current Assets ÷ Current Liabilities
Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) ÷ Current Liabilities
Here:
Current Assets include cash, accounts receivable, inventory, and other assets due within 12 months.
Current Liabilities include obligations such as accounts payable, short-term loans, and accrued expenses.
Example:
Company X has:
Current Assets = ₹15 Crores
Current Liabilities = ₹7.5 Crores
Current Ratio = ₹15 Cr ÷ ₹7.5 Cr = 2.0
This means the company has twice as many current assets as current liabilities, suggesting current assets exceed current liabilities.
Example:
Company Y has:
Current Assets = ₹20 Crores
Inventory = ₹6 Crores
Prepaid Expenses = ₹2 Crores
Current Liabilities = ₹10 Crores
Quick Ratio = (₹20 Cr – ₹6 Cr – ₹2 Cr) ÷ ₹10 Cr = ₹12 Cr ÷ ₹10 Cr = 1.2
This indicates that Company Y can cover its short-term liabilities with readily available assets.
Here’s a comparison of the two ratios for clarity:
| Aspect | Current Ratio | Quick Ratio (Acid-Test) |
|---|---|---|
Definition |
Measures short-term liquidity using all current assets |
Measures short-term liquidity using only quick assets |
Assets Included |
Cash, receivables, inventory, prepaid assets |
Cash, receivables, short-term investments only |
Conservativeness |
Less strict |
More conservative |
Reliability |
May overstate liquidity if inventory is hard to liquidate |
Provides a clearer view of immediate liquidity |
Usefulness |
General liquidity analysis |
Situations where inventory may not be quickly sold |
These ratios are important because they:
Assess Liquidity: Indicate whether a company can pay off debts due within a year.
Aid Credit Decisions: Used by lenders to evaluate repayment ability.
Support Risk Analysis: Help investors understand short-term financial stability.
Enable Comparisons: Useful for benchmarking companies within the same industry.
Despite their usefulness, both ratios have certain drawbacks:
They provide only a snapshot of liquidity at one point in time.
They ignore the timing of receivables and payables.
High ratios may suggest inefficiency in asset utilisation.
Low ratios may not always mean distress if the company has strong cash inflows.
Industry variations can make cross-comparisons misleading.
Example 1 – Current Ratio:
A retail company with current assets of ₹50 Crores and current liabilities of ₹25 Crores has a current ratio of 2.0.
Example 2 – Quick Ratio:
The same company has ₹20 Crores in inventory and prepaid expenses. Quick Ratio = (₹50 Cr – ₹20 Cr) ÷ ₹25 Cr = 1.2.
These examples show how excluding inventory can significantly change liquidity assessment.
Current ratio and quick ratio are essential tools to gauge a company’s ability to meet short-term obligations. While the current ratio gives a broader picture, the quick ratio provides a stricter test of immediate liquidity. Both should be used together, along with other financial indicators, to assess overall financial health.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
The current ratio measures a company’s ability to pay short-term obligations by considering all current assets, including inventory and prepaid expenses. The quick ratio, on the other hand, excludes inventory and prepaid expenses to provide a stricter assessment of liquidity using only the most liquid assets.
A quick ratio of 2.5 means that a company has ₹2.5 in quick assets for every ₹1 of current liabilities. This suggests that the business has a strong ability to cover its short-term obligations without relying on inventory sales.
A common rule of thumb for the current ratio is that a value above 1 indicates current assets are greater than current liabilities. However, the commonly referenced benchmark ratio can differ across industries depending on working capital requirements and operating models.
The quick ratio is also known as the acid-test ratio because it uses only the most liquid assets, such as cash, marketable securities, and receivables. This offers an immediate and strict test of a company’s short-term financial health.
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