The difference between current ratio and quick ratio
/The current ratio and quick ratio are both designed to estimate the ability of a business to pay for its current liabilities. While they are fairly similar, there is one important difference in how they are calculated, which can lead to notably different outcomes. You should be aware of this difference, which we will cover in detail.
What is the Current Ratio?
The current ratio measures the ability of a business to pay for its current liabilities with its existing current assets. This means that the current ratio compares the current assets and current liabilities reported on a firm’s balance sheet. The formula for it is as follows:
Current ratio = (Cash + Marketable securities + Receivables + Inventory) ÷ Current liabilities
What is the Quick Ratio?
The quick ratio is the same as the current ratio, except that inventory is not included in the current assets portion of the calculation. The reason for this exclusion is that inventory can be difficult to liquidate in the short term; some inventory items may require many months to sell, and possibly at reduced prices. The formula for the quick ratio is as follows:
Quick ratio = (Cash + Marketable securities + Receivables) ÷ Current liabilities
The Difference Between the Current Ratio and Quick Ratio
The difference between the two measurements is that the quick ratio focuses on the more liquid assets, and so gives a better view of how well a business can pay off its obligations. The current ratio is oriented toward a somewhat longer period of time (whatever is needed to sell off inventory), and so may not be the best option for judging the short-term liquidity of a business. In short, the difference between the two ratios is the use (or non-use) of inventory. Inventory is a questionable item to include in an analysis of the liquidity of a business, since it can be quite difficult to convert to cash in the short term. Even if it can be sold within a reasonably short period of time, it is now a receivable (if sold on credit), and so there is an additional wait until the buyer pays the receivable. Consequently, the more reliable measure of short-term liquidity is the quick ratio. The only exception is when a business has a history of high inventory turnover (such as a grocery store), where inventory is not only sold off with great rapidity, but also where the resulting sales are converted to cash very quickly.
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As an example of the difference between the two ratios, a retailer reports the following information:
Cash = $50,000
Receivables = $250,000
Inventory = $600,000
Current liabilities = $300,000
The current ratio of the business is 3:1, while its quick ratio is a much smaller 1:1. In this case, the presence of a large proportion of inventory is masking a relatively low level of liquidity, which could be a concern to a lender or supplier.