However, the current ratio doesn’t offer as conservative a measure as the quick ratio since it includes assets that may be harder to convert to cash quickly. The quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. The Quick Ratio, also known as the Acid-test or Liquidity ratio, measures the ability of a business to pay its short-term liabilities by having assets balance sheet accounts that are readily convertible into cash.

Company A also has fewer wages payable, which is the liability most likely to be paid in the short term. The current ratio can be a useful measure of a company’s short-term solvency when it is placed in the context of what has been historically normal for the company and its peer group. It also offers more insight when calculated repeatedly over several periods.

Current ratio vs. quick ratio: Which one is more relevant for your SaaS business

The quick ratio measures a company’s ability to pay off its current liabilities using cash or cash equivalents. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company and then dividing it by its total current liabilities. It helps the investors estimate the company’s ability to clear out its current liabilities at the earliest or meet its obligations for the short term. The quick ratio is more stringent in measuring liquidity, often referred to as the acid-test ratio. The quick ratio gives a more accurate picture of how likely a company is to fulfill its short-term obligations through the sale of less liquid current assets.

How to Calculate the Current Ratio and the Quick Ratio?

The current ratio provides the most information when it is used to compare companies of similar sizes within the same industry. Since assets and liabilities change over time, it is also helpful to calculate a company’s current ratio from year to year to analyze whether it shows a positive or negative trend. In this example, although both companies seem similar, Company B is likely in what is gross profit a more liquid and solvent position. An investor can dig deeper into the details of a current ratio comparison by evaluating other liquidity ratios that are more narrowly focused than the current ratio. In its Q fiscal results, Apple Inc. reported total current assets of $135.4 billion, slightly higher than its total current assets at the end of the 2021 fiscal year of $134.8 billion.

What Happens If the Quick Ratio Indicates a Firm Is Not Liquid?

This could lead to liquidity problems, which might require the company to borrow more or sell assets at unfavorable terms just to keep the lights on. Understanding your company’s liquidity—the ease and speed of converting assets into cash—is crucial for making informed financial decisions. Companies with strong liquidity positions are better equipped to navigate economic uncertainties and capitalize on growth opportunities. Finally, the operating cash flow ratio compares a company’s active cash flow from operating activities (CFO) to its current liabilities. This allows a company to better gauge funding capabilities by omitting implications created by accounting entries.

Here’s a look at both ratios, how to calculate them, and their key differences. The ratio refers to an arithmetical expression, representing the proportion of one thing with respect to another. It is used to show the financial health and position, earning capacity and operating efficiency of the concern. ProfitWell Metrics provides real-time, accurate subscription reporting and analytics in one dashboard. It uses a secure and GDPR-compliant system that integrates seamlessly with various platforms, including Stripe, ReCharge, Braintree, Chargify, and more. ProfitWell pulls data about your business performance and customers into an intuitive dashboard.

  • With both values in hand, one can proceed to calculate the current ratio by dividing the total current assets by the total current liabilities.
  • Prepaid expenses can be a smart way of managing cash flow, and a little debt now can mean significant savings later.
  • While calculating the quick ratio, we consider all the current assets except inventories.
  • The current ratio provides insight into a company’s short-term financial health, particularly its liquidity and ability to pay off imminent debts using its most liquid assets.
  • A current ratio of 1.5 would indicate that the company has $1.50 of current assets for every $1 of current liabilities.
  • Additionally, differences in accounting practices or inventory valuation methods can also impact the ratios’ accuracy.
  • By excluding inventory, and other less liquid assets, the quick ratio focuses on the company’s more liquid assets.

Key Differences Between Current Ratio and Quick Ratio

By analyzing liquidity, stakeholders can identify potential cash flow issues and take proactive measures to address them. Liquidity analysis helps reveal any potential gaps between cash inflows and outflows, enabling companies to implement effective cash management strategies. As with the current activity-based cost systems allocate costs by focusing on ratio, industry norms and standards may differ, making it important to compare a company’s quick ratio against industry benchmarks for a more accurate analysis. Seasonal businesses may experience fluctuations in their current ratio due to varying levels of activity throughout the year. For example, a retail company may have higher inventory levels during the holiday season, resulting in a lower current ratio during that period.

  • A quick ratio above 1 means the company can pay its current liabilities without selling its inventory.
  • Both the quick ratio and current ratio are important tools for assessing a company’s liquidity.
  • In addition, though its quick ratio only dropped a little, there are bigger changes in cash on hand vs. the balances in accounts receivable.
  • Below is a break down of subject weightings in the FMVA® financial analyst program.
  • In fact, such a company may be viewed favorably by the equity or debt capital markets and be able to raise capital easily.
  • The current ratio is a direct measure of this liquidity and is pivotal in assessing a company’s short-term financial health.
  • Both the current ratio and quick ratio have their merits; the choice depends on the context.

Below is the table showing these differences and the contribution of inventory and prepaid expenses to Current Assets. If we get all we need to know as investors from the current ratio, why should we look at a quick ratio? If new financing cannot be found, the company may be forced to liquidate assets in a fire sale or seek bankruptcy protection. This capital could be used to generate company growth or invest in new markets. There is often a fine line between balancing short-term cash needs and spending capital for long-term potential. Below is the calculation of the quick ratio based on the figures that appear on the balance sheets of two leading competitors operating in the personal care industrial sector, ABC and XYZ.

While they are fairly similar, there is one important difference in how they are calculated, which can lead to notably different outcomes. In this example, Company A has much more inventory than Company B, which will be harder to turn into cash in the short term. Perhaps this inventory is overstocked or unwanted, which eventually may reduce its value on the balance sheet. Company B has more cash, which is the most liquid asset, and more accounts receivable, which could be collected more quickly than liquidating inventory. Although the total value of current assets matches, Company B is in a more liquid, solvent position. Companies may use days sales outstanding to better understand how long it takes for a company to collect payments after credit sales have been made.