As a small business owner, you’re well aware of the importance of accurate financial data. Financial statements provide you with vital details about the health of your business, reporting information such as total assets and liabilities, net income, and cash flow.
Of course, the choice to use accounting software can also play a role in the reporting process, automating the bookkeeping and accounting process, while ensuring the financial statements you produce are accurate.
But if you’re ready to take financial management and analysis one step further, accounting ratios might be the solution. Ratios such as the current ratio and the quick ratio are easily calculated, giving you a brand new way of looking at your business finances.
Both are considered liquidity ratios, and both let you know if you have enough current or liquid assets to pay off all of your bills, should they come due.
Still not convinced?
Consider this. What if your bills suddenly became due today, would you be able to pay them off? If you already know the answer, that’s great. But if you don’t, both the current ratio and the quick ratio can give you that answer in seconds.
Though similar, the current ratio and the quick ratio do differ slightly, which we’ll explore in detail next.
What is the current ratio?
The current ratio measures the ability of your business to pay your current liabilities using your current assets. While there are many asset types, you’ll only include current assets in your current ratio calculation. Current assets are assets that can be converted into cash within one year. Current assets may include the following:
- Cash and cash equivalents
- Accounts receivable
- Prepaid expenses
- Securities (marketable or liquid)
Like assets, there are various liabilities, but you’ll only be including your current liabilities in the current ratio calculation. Current liabilities are debts that are due and payable within a year. These include:
- Accounts payable
- Accrued liabilities
- Short-term debt (debt due within 12 months)
How to calculate the current ratio
The current ratio formula is simple. Simply take your current asset total and divide the total by your current liability total.
Current Ratio = Current Assets ÷ Current Liabilities
For example, in December of 2019, Jane’s balance sheet reflected the following amounts.
Jane’s Pet Store
|Total Current Assets||$28,100|
|Total Current Liabilities||$6,600|
Knowing Jane has total current assets of $28,100 and total current liabilities of $6,600, her current ratio can be calculated:
$28,100 ÷ $6,600 = 4.26
This shows that for every $1 that Jane has in current liabilities, she has $4.26 worth of current assets. A good current ratio is 2, indicating you have twice as much in assets as liabilities.
A current ratio of less than 2 may indicate financial issues and an inability to pay off current debts, while a current ratio over 4 may indicate that your business is not using its assets efficiently.
What is the quick ratio?
The quick ratio, also called the acid-test ratio is similar to the current ratio, but is considered a more conservative calculation, as it only includes assets that can be converted to cash in 90 days or less.
How to calculate the quick ratio
To use the quick ratio formula for Jane’s pet store, you’ll need to eliminate both inventory and prepaid expenses in the calculation, since neither can be converted to cash within 90 days.
You can calculate the quick ratio by adding cash and cash equivalents, current accounts receivable, and short-term investments and dividing that total by your current liabilities:
Quick Ratio = Cash + Cash Equivalents + Accounts Receivable + Short-Term Investments ÷ Current Liabilities
Jane’s Pet Store
|Prepaid Expenses (don’t use)||$1,000|
|Inventory (don’t use)||$11,500|
|Total Current Assets||$28,500|
|Accounts Payable $ 5,500||$5,500|
|Total Current Liabilities||$6,600|
While Jane’s current assets total $28,100 on her balance sheet, when calculating the quick ratio, you only want to include liquid assets, which would be cash in the amount of $12,500 and accounts receivable in the amount of $3,100 for a total of $15,600.
All current liabilities should be included in the calculation for the quick ratio:
$15,600 ÷ $6,600 = 2.36
Jane’s quick ratio is 2.36, meaning that after we remove inventory and prepaid expenses, her business now has $2.36 in assets for every $1 in liabilities, which is a very good ratio.
It’s recommended a quick ratio be at least 1, indicating that for every dollar you have in liabilities, you have $1 in assets. If comparing your quick ratio to other companies, only compare to businesses in your industry.
For example, a retail business with large amounts of inventory will have a very different current ratio than a service business.
As with the current ratio, a quick ratio of less than 1 indicates an inability to cover current debt, while a quick ratio that is too high may indicate that your business is not using assets efficiently.
Current ratio vs. quick ratio: What’s the difference?
Both the current ratio and the quick ratio are considered liquidity ratios, measuring the ability of a business to meet its current debt obligations. The current ratio includes all current assets in its calculation, while the quick ratio only includes quick assets or liquid assets in its calculation.
Considered the more conservative ratio, the quick ratio only considers assets that can be quickly converted to cash, whereas the current ratio also includes inventory, which is an asset, but in most cases cannot be converted into cash within 90 days or less.
|Current Ratio||Quick Ratio|
|Considers assets that can be converted to cash within a year||Considers only assets that can be converted to cash in 90 days or less|
|Includes inventory||Excludes inventory|
|Ideal result is 2:1||Ideal result is 1:1|
When should you use the current ratio or quick ratio?
If you’re worried about covering debt in the next 90 days, the quick ratio is the better ratio to use. If you’re looking for a longer view of liquidity, the current ratio, which includes inventory, is better.
Keep in mind that if your business does not have inventory assets, the two ratios are nearly identical, with both ratios providing the same results.
Final thoughts on the current ratio and quick ratio
When calculating ratios for your business, it’s always important to calculate more than one ratio. Both the current ratio and the quick ratio will give you a measure of liquidity for your business, but combining these ratios with other accounting ratios will give you a much clearer picture of your business finances.
Accounting ratios such as the current ratio and the quick ratio can also help you quickly identify trouble spots and if your business is headed in the wrong direction. The results of these ratios may also be helpful when creating financial projections for your business.
But it’s not enough to simply calculate an accounting ratio. To properly use the results of any accounting ratio, you must understand what the results mean and use that information to your advantage.
Taking charge of your business finances puts you one step closer to success. So, take a deep breath, grab your balance sheet, and calculate a ratio today.