It is foolhardy to assess a company’s financial performance on the basis of one or two economic indicators as financial experts will tell you. However, in reality it is common for people to have a look at some of the common performance indicators to gain an insight into company’s performance. In fact, experts say, and there are enough examples to support it, that Quick ratio and Current ratio are two parameters that can detect trouble much earlier than other economic indicators and can forecast failure 5 years before it actually takes place. Just what are these ratios and what is the difference between them? Let us find out in this article.
Both quick ratio and current ratio are called liquidity ratios and reflect a company’s ability to meet its short term obligations. Liquidity of a company is said to be an indicator of its financial health. Two of the most common liquidity ratios are Current and Quick ratios. The use of the word current in current ratio implies current assets and current liabilities, and in fact, it is a ratio of these two only.
Current ratio = current assets/ current liabilities
Quick ratio = (cash + marketable securities + net receivables) / current liabilities
It is clear then that while inventories are taken into account in the case of current ratio, they are overlooked in the case of quick ratio.
It might be confusing for some to see either of the liquidity ratios being used to analyze financial performance. Which of these ratios is a better indicator of a company’s financial health in the short term is not easy to tell. As far as quick ratio is concerned, it is considered to be a more conservative indicator than current ratio. As long as the ratio is positive and greater than one, there is no danger of the company not being able to meet its short term obligations. The situation is obviously more complex when quick ratio is positive, but less than one and the current ratio is greater than one. This situation demands valuation of inventory and inventory turnover.
In general a current ratio of 1.5 or more suggests that the company can meet its short term liabilities quite easily but a higher ratio means that the company is hoarding its assets rather than making best use of these assets. Though, this is not bad, it can certainly affect long term returns on capital.
If a company has an overwhelming proportion of its current assets tied up in the form of inventories, it will need to sell off inventories to meet short term obligations. This means that if the sales of the company are not growing that quickly, the company might be forced to take debt to meet its obligations. This is where quick ratio comes in handy as it takes away inventories out of equation and still finds out if a company has enough liquidity to meet its short term obligations.
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What is the difference between Quick Ratio and Current Ratio? • Both quick ratio and current ratio are measures to judge the performance of a company, and are referred to as liquidity ratios. • Current ratio is the ratio of current assets and current liabilities and if it is 1.5, it is said that there is enough liquidity in a company to meet its short term obligations. However, a ratio of 2 means that the assets are not being utilized productively, and it may have adverse effect on long term prospects of the company • Current ratio takes into account liabilities, whereas quick ratio does not.
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