Current Ratio vs Quick Ratio – Toll Brothers current ratio is at 4.64x, however, its quick ratio is comparatively low at 0.36x. Why is it so? Is this good or bad for the company?
Both Current Ratio and Quick ratio are liquidity ratios and are extremely helpful to Financial Statement Analysis.
In this article, we look at Current Ratio vs Quick Ratio, how they are calculated, their key differences etc –
- Current Ratio vs Quick Ratio – Meaning
- Current Ratio vs Quick Ratio – Formula
- Current Ratio vs Quick Ratio – Interpretation
- Current Ratio vs Quick Ratio – Basic Example
- Colgate – Calculate Current Ratio and Quick Ratio
- Apple’s Current Ratio and Quick Ratio
- Microsoft’s Current Ratio and Quick Ratio
- Software Application Sector – Current Ratio vs Quick Ratio Examples
- Steel Sector – Current Ratio vs Quick Ratio Examples
- Tobacco Sector – Current Ratio vs Quick Ratio Examples
- Current Ratio vs Quick Ratio – Limitations
- In the final analysis
Current Ratio vs Quick Ratio – Meaning
As an investor, if you want a quick review of how a company is doing financially, you must look at current ratio of the company. Current ratio means company’s ability to pay off short term liabilities with its short term assets. Usually, when the creditors are looking at a company, they look for higher current ratio; because a higher current ratio will ensure that they will get repaid easily and the certainty of payment would increase.
So what current ratio is all about? We will simply look at the balance sheet of the company and then select the current assets and divide the current assets by current liabilities of the company during the same period.
If we get all we need to know as investors from current ratio, why should we look at quick ratio? Here’s the catch.
Quick ratio helps investors get to the bottom of things and discover whether the company has ability to pay off its current obligations. There is only one thing that’s different in quick ratio than current ratio. While calculating the quick ratio, we take into account all the current assets except inventories. Many financial analysts feel that inventory takes a lot of time to turn itself into cash to pay off debt. In some cases, we also exclude prepaid expenses to get to the quick ratio. Thus, quick ratio is a better starting point to understand whether the company has the ability to pay off its short term obligations. Quick ratio is also called acid test ratio.
As we saw earlier that Toll Brothers had current ratio of 4.6x. this makes us believe that they are in best position to meet their current liabilities. However, when we calculate Quick ratio, we note that its only 0.36x. This is due to high levels of Inventory in the balance sheet as seen below.
source: Toll Brothers SEC Filings
Current Ratio vs Quick Ratio – Formula
Current Ratio Formula
Let’s look at the formula of current ratio first.
Current Ratio = Current Assets / Current Liabilities
As you can see, current ratio is simple. Just go over to the balance sheet of the company and select “current assets” and divide the sum by “current liabilities” and you get to know the ratio.
But what do we include in the current assets?
Current Assets: Under current assets, the company would include cash including the foreign currency, short term investments, accounts receivables, inventories, prepaid expenses etc.
Current liabilities: Current Liabilities are liabilities which are due in the next 12 months or less. Under current liabilities, the firms would include accounts payable, sales taxes payable, income taxes payable, interest payable, bank overdrafts, payroll taxes payable, customer deposits in advance, accrued expenses, short term loans, current maturities of long term debt etc.
Now, let’s look at quick ratio. We look at quick ratio in two ways.
Quick Ratio Formula # 1
Quick Ratio = (Cash & Cash Equivalents + Short Term Investments + Accounts Receivables) / Current Liabilities
Here, if you notice everything is taken under current assets except inventories.
Let’s look at what we include in cash & cash equivalents, short term investments and account receivables.
Cash & Cash Equivalents: Under Cash, the firms include coins & paper money, un-deposited receipts, checking accounts and money order. And under cash equivalent, the organizations take into account money market mutual funds, treasury securities, preferred stocks which have maturity of 90 days or less, bank certificates of deposits and commercial paper.
Short Term Investments: These investments are short term which can be liquidated easily within a short period usually within 90 days or less.
Accounts Receivables: The sum of money that is yet to be received from the debtors of the company is called accounts receivable; including accounts receivable is criticized by some of the analysts because there is less certainty in liquidation of accounts receivable!
Quick Ratio Formula # 2
Let’s look at the second way of computing quick ratio (acid test ratio) –
Quick Ratio = (Total current assets – Inventory – Prepaid Expenses) / Current Liabilities
In this case, you can take the whole current assets from the balance sheet of the company and then simply deduct the inventories and prepaid expenses. Then divide the figure by current liabilities to get to the quick or acid test ratio.
Current Ratio vs Quick Ratio – Interpretation
First, we will interpret the current ratio and then quick ratio.
- When creditors look at current ratio, it’s usually because they want to ensure the certainty of repayment.
- If a company has less than 1 as their current ratio, then the creditors can understand that the company will not be able to easily pay off their short term obligations.
- And if the current ratio of the company is more than 1, then they are in a better position to liquidate their current assets to pay off the short term liabilities.
- But what if the current ratio of a company is too higher? For example, let’s say that Company A has a current ratio of 5 in a given year, what would be the possible interpretation? There are actually two ways of looking at it. First, they are doing exceptionally good so that they can liquidate their current assets so very well and pay off debts faster. Second, the company is not able to utilize its assets well and thus, the current assets are much more than current liabilities of the company.
Now, let’s have a look at quick ratio.
- Many financial analysts believe that quick ratio is much better way to start off understanding a company’s financial affairs than current ratio. Their argument
- Their argument is inventories shouldn’t be included in the expectation of paying off current liabilities because no-one knows how long it would take to liquidate inventories. It is similar
- It is similar with prepaid expenses. Prepaid expense is the amount paid in advance for goods and services to be received in future. As it is something that is already paid, it can’t be used to pay off further obligation. So we deduct prepaid expense as well from the current assets while computing quick ratio. In
- In case of quick ratio as well, if the ratio is more than 1; creditors believe company is doing well and vice versa.
Current Ratio vs Quick Ratio – Basic Example
We will two examples through which we will try to understand current ratio and quick ratio.
Let’s have a look.
Current Ratio vs Quick Ratio Example # 1
X (in US $) | Y (in US $) | |
Cash | 10000 | 3000 |
Cash Equivalent | 1000 | 500 |
Accounts Receivable | 1000 | 5000 |
Inventories | 500 | 6000 |
Accounts Payable | 4000 | 3000 |
Current Taxes Payable | 5000 | 6000 |
Current Long-term Liabilities | 11000 | 9000 |
Compute “Current Ratio” and “Quick Ratio”.
First, let’s start with current ratio.
Here’s what we will include in current assets –
X (in US $) | Y (in US $) | |
Cash | 10000 | 3000 |
Cash Equivalent | 1000 | 500 |
Accounts Receivable | 1000 | 5000 |
Inventories | 500 | 6000 |
Total Current Assets | 12500 | 14500 |
We will look at current liabilities now –
X (in US $) | Y (in US $) | |
Accounts Payable | 4000 | 3000 |
Current Taxes Payable | 5000 | 6000 |
Current Long-term Liabilities | 11000 | 9000 |
Total Current Liabilities | 20000 | 18000 |
Now we can easily calculate the current ratio.
Current ratio of X & Y would be –
X (in US $) | Y (in US $) | |
Total Current Assets (A) | 12500 | 14500 |
Total Current Liabilities (B) | 20000 | 18000 |
Current Ratio (A / B) | 0.63 | 0.81 |
From the above, it can be easily said that both X & Y need to improve their current ratio to be able to pay off their short term obligations.
Let’s look at quick ratio now.
For calculating quick ratio, we just need to exclude “inventories” as there is no “prepaid expenses” given.
X (in US $) | Y (in US $) | |
Cash | 10000 | 3000 |
Cash Equivalent | 1000 | 500 |
Accounts Receivable | 1000 | 5000 |
Total Current Assets
(Except “Inventories”) |
12000 | 8500 |
Now the quick ratio would be –
X (in US $) | Y (in US $) | |
Total Current Assets (M) | 12000 | 8500 |
Total Current Liabilities (N) | 20000 | 18000 |
Current Ratio (M / N) | 0.60 | 0.47 |
One thing is noticeable here. For X, there is not much difference in the quick ratio because of excluding inventories. But in case of Y, there is huge difference. That means inventories can inflate the ratio and can give creditors more hope in getting paid.
Current Ratio vs Quick Ratio Example # 2
Paul has started a clothing store few years back. Paul wants to expand his business and needs to take a loan from the bank to do so. Bank asks for a balance sheet to understand the quick ratio of Paul’s clothing store. Here are the details below –
Cash: US $15,000
Accounts Receivable: US $3,000
Inventory: US $4,000
Stock Investments: US $4,000
Prepaid taxes: US $1500
Current Liabilities: US $20,000
Compute “Quick Ratio” on behalf of the bank.
As we know that “inventory” and “prepaid taxes” wouldn’t be included in the quick ratio, we will get the current assets as follows
(Cash + Accounts Receivable + Stock Investments) = US $(15,000 + 3,000 + 4,000) = US $22,000.
And the current liabilities are mentioned i.e. – US $20,000.
Then, the quick ratio would be = 22,000 / 20,000 = 1.1.
Quick ratio of more than 1 is good enough for bank to start off. Now the bank will look at more ratios to think over whether to lend loan to Paul for expanding his business.
Colgate – Calculate Current Ratio and Quick Ratio
In this example, let us look at how to calculate Current Ratio and Quick Ratio of Colgate. If you wish to get access to calcluationexcel sheet, then you can download the same here – Ratio Analysis in Excel
Colgate’s Current Ratio
Below is the snapshot of Colgate’s Balance Sheet for years from 2010 – 2013.
Current Ratio is easy to calculate = Current Assets of Colgate divided by Current Liability of Colgate.
For example, in 2011, Current Assets was $4,402 million and Current Liability was $3,716 million.
Colgate Current Ratio (2011) = 4,402/3,716 = 1.18x
Likewise we can calculate the current ratio for all other years.
Following observations can be made with regards to Colgate Current Ratios –
- Current ratio increased from 1.00x in 2010 to 1.22x in year 2012.
- Colgate’s current ratio increased due to increase in cash and cash equivalents and other assets from 2010 to 2012. In addition, we saw that the current liabilities were more or less stagnant at around $3,700 million for these three years.
- Current ratio dipped to 1.08x in 2013 due to increase in current liabilities caused by current portion of long term debt to $895 million.
Colgate’s Quick Ratio
Now that we have calculated Current Ratio, we calculate Quick Ratio of Colgate. Quick ratio only considers receivables and cash and cash equivalents in the numerator.
Quick Ratio of Colgate is relatively healthy (between 0.56x – 0.73x). This acid test shows us the company’s ability to pay off short term liabilities using Receivables and Cash & Cash Equivalents. We note that Colgate has reasonable level of cash and receivables to pay a sizable portion of current liabilities.
Apple’s Current Ratio and Quick Ratio
Now that we know the calculation of Current Ratio and quick ratio, let us compare the two for Apple (product company). Below graph depicts Current Ratio and Quick Ratio of Apple for the past 10 years.
source: ycharts
We note the following from the above graph –
- Current Ratio of Apple currently is 1.35x, while its Quick Ratio is 1.22x. These two ratios are very close to each other.
- There is not much difference in these two ratios. We note that historically, they have stayed very close to each other.
- The key reason for this is that Apple has most of its current assets as Cash & Cash Equivalents, Marketable Securities, and Receivables.
- Inventory as a percentage of Current Assets is insignificant (less than 2%) as seen from the balance sheet below.
source: Apple SEC filings
Microsoft’s Current Ratio and Quick Ratio
Now that we have seen Apple’s comparison, it is easy to guess how the graph of Microsoft Current Ratio vs Quick Ratio will look like.
Below chart plots Microsoft’s Quick and Current ratio for the past 10 years.
source: ycharts
We note the following –
- Current Ratio is currently at 2.35x, while the quick ratio is at 2.21x
- This is again a narrow range, just like Apple
- The key reason for this is that Inventory is a miniscule part of the total current assets.
- current assets primarily consists of Cash and Cash Equivalents, Short Term Investments and receivables.
source: Microsoft SEC Filings
Software Application Sector – Current Ratio vs Quick Ratio Examples
Let us now look at sector specific Current Ratio and Quick Ratio Comparisons. We note Sofware applications companies has a very narrow range of Current Ratio and Quick Ratios.
Below is a list of top Software Application companies –
source: ycharts
- SAP has a current ratio of 1.24x, while its quick ratio is 1.18x.
- Likewise, Adobe Systems has a current ratio of 2.08 vs a quick ratio of 1.99x
- Software companies are not dependent on inventory and hence, its contribution to current assets is very less.
- We note from the table above that (Inventories + Prepaid)/Current Assets is very low.
Steel Sector – Current Ratio vs Quick Ratio Examples
In contrast to software companies, Steel companies are capital intensive sector and is heavily dependent on Inventories.
Below is a list of top Steel companies –
source: ycharts
- We note that Arcelor Mittal Current Ratio is 1.24x, while its Quick Ratio is 0.42
- Likewise, for ThyssenKrupp, current ratio is at 1.13 vs Quick ratio of 0.59
- We note that the range (Current ratio – quick Ratio) is relatively broad here.
- This is because, for such companies, inventories and prepaid contribute a very large percentage of Current Assets (as seen from above, contribution is greater than 30% in these companies)
Tobacco Sector – Current Ratio vs Quick Ratio Examples
Another example that we see here is of Tobacco Sector. We note that this is fairly capital intensive sector and depends on a lot on storing raw material, WIP and finished goods inventories. Therefore, Tobacco sector also shows a broad difference between Current Ratio and Quick Ratio.
Below is the table showing these differences as well as the contribution of inventory and prepaid expenses to Current Assets.
source: ycharts
Current Ratio vs Quick Ratio – Limitations
Let’s discuss the disadvantages of both of these ratios.
Here are the disadvantages of current ratio –
- First of all, only current ratio would not give an investor a clear picture about the liquidity position of a company. The investor needs to look at other ratios like quick ratio and cash ratio as well.
- Current ratio includes inventories and other current assets into account which may inflate the figure. Thus, current ratio doesn’t always give the right idea about the liquidity of a company.
- If sales are depending on seasons for any particular company or industry, then current ratio may vary over the year.
- The way inventory is valued will impact the current ratio as it includes inventory in its calculation.
Quick ratio is a better way to look at the liquidity of the company. But it still has some demerits. Let’s have a look –
- First of all, no investor and creditor should depend on acid test or quick ratio only to understand the liquidity position of a company. They also need to look at cash ratio and current ratio to compare. And they also should check out how much the company depends on its inventory.
- Quick ratio includes accounts receivables which may not get liquidated quickly. And as a result, it may not give an accurate picture.
- Quick ratio excludes inventories in all occasions. But in case of inventory intensive industry like supermarkets, quick ratio isn’t able to provide an accurate picture due to exclusion of inventories from the current assets.
In the final analysis
To be clear about the liquidity position of a company, only current ratio and quick ratio are not enough, the investors and creditors should look at the cash ratio as well. And they need to find out which industry and company they are calculating for; because in every occasion the same ratio wouldn’t give the accurate picture. As a whole, they should look at all the liquidity ratios before drawing any conclusions.
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