The difference between current ratio and quick ratio

The current ratio and quick ratio are both designed to estimate the ability of a business to pay for its current liabilities. The difference between the two measurements is that the quick ratio focuses on the more liquid assets, and so gives a better view of how well a business can pay off its obligations.

Their formulas are:

Current ratio = (Cash + Marketable securities + Receivables + Inventory) ÷ Current liabilities

Quick ratio = (Cash + Marketable securities + Receivables) ÷ Current liabilities

Thus, the difference between the two ratios is the use (or non-use) of inventory. Inventory is a questionable item to include in an analysis of the liquidity of a business, since it can be quite difficult to convert to cash in the short term. Even if it can be sold within a reasonably short period of time, it is now a receivable (if sold on credit), and so there is an additional wait until the buyer pays the receivable. Consequently, the more reliable measure of short-term liquidity is the quick ratio. The only exception is when a business has a history of high inventory turnover (such as a grocery store), where inventory is not only sold off with great rapidity, but also where the resulting sales are converted to cash very quickly.

As an example of the difference between the two ratios, a retailer reports the following information:

Cash = $50,000
Receivables = $250,000
Inventory = $600,000
Current liabilities = $300,000

The current ratio of the business is 3:1, while its quick ratio is a much smaller 1:1. In this case, the presence of a large proportion of inventory is masking a relatively low level of liquidity, which could be a concern to a lender or supplier.

Related Courses

Business Ratios Guidebook 
The Interpretation of Financial Statements