Generally, fundamental analysis is an excellent way to analyze a company’s financial performance before investing in it. There are several calculations, formulas and ratios used in fundamental analysis. Significantly, liquidity ratios play a crucial role in this analysis. To point out, liquidity ratios always show the financial strength as the investors favour companies with strong liquidity ratio. Here, let’s discuss about the liquidity ratios, current ratio and quick ratio.
Current ratio generally determines if a company is capable to pay off all of its current liabilities with current assets. To explain, the term ‘Current liabilities’ refers to all the short-term debts of a firm which are payable within a year. Likewise, Current assets refers to the short-term assets of a firm which are easily convertible to cash within a year.
Current ratio = current assets / current liabilities
The ideal value for current ratio is 1. The companies with less than 1 ratio means that they don’t have the required assets to pay off all of their liabilities if they fall.
Quick ratio particularly determines how efficient is the company’s ability to pay off all of its current liabilities with current assets. This is a more conservative method of calculation. This is because it only considers the present assets that liquidate in less than 90 days. Another name for quick ratio is acid-test ratio.
Quick ratio= (cash + cash equivalents + current receivables + short-term investments) / current liabilities
The preferred value of quick ratio is 1. Companies with less than 1 ratio means that they are not capable to meet the liabilities if it all fall at the same time.
DIFFERENCE BETWEEN CURRENT AND QUICK LIQUIDITY RATIOS
|QUICK RATIO||CURRENT RATIO|
|More conservative approach||More relaxed approach|
|Calculates the proportion of highly liquid assets to current liabilities||Calculates the proportion of current assets to current liabilities|
|Considers the current assets that liquidates to cash within 90 days||Considers all the current assets of the company|
|Does not include a company’s inventories||Also includes the inventory stocks|
|Significantly, 1:1 ratio is advantageous||2:1 is advantageous along with anything more than 1|
|For firms with strong inventory stocks, quick ratio is especially low||For firms with strong inventory stocks, current ratio is specifically high|
Even though these ratios seem similar at first sight, their differences are large and direct. Important to realize, instead of wasting time in determining which ratio is better, investors should use both to analyze the liquidity level of a company.