Current and Quick Ratios
If current liabilities become too high relative to current assets — which constitute the first line of defense for paying current liabilities — managers should move quickly to resolve the problem. A perceived shortage of current assets relative to current liabilities could sound the sirens in the minds of the company’s creditors and owners. The current and quick ratios measure this risk.
Making a judgment about the ratios you compute depends on your industry. However, a current ratio of at least 1.0 is considered a minimum expectation for company liquidity (see the earlier section on liquidity). At that ratio, you have at least $1 in current assets to pay each dollar of current liabilities.
Business managers know that acceptable ratios also depend on general practices in the industry for short-term borrowing. Some businesses do well with current ratios less than 2.0 and quick ratios less than 1.0; so take these benchmarks with a grain of salt. Lower ratios don’t necessarily mean that the business won’t be able to pay its short-term (current) liabilities on time.
Applying the current ratio
Current assets are the first source of money to pay current liabilities when these liabilities come due. Remember that current assets consist of cash and assets that will be converted into cash in the short run. Ideally, a company will use current assets as a payment source, rather than additional borrowing or other financing.
To size up current assets against total current liabilities, the current ratio is calculated. Using information from the company’s balance sheet, you compute its year-end 2015 current ratio as follows:
$8,815,000 current assets / $4,030,000 current liabilities = 2.2 current ratio
Generally, businesses don’t provide their current ratio on the face of their balance sheets or in the footnotes to their financial statements — they leave it to the reader to calculate this number. On the other hand, many businesses present a financial highlights section in their financial report, which often includes several financial ratios.
Moving to the quick ratio
The quick ratio is more restrictive than the current ratio. Only cash and assets that can be immediately converted into cash are included, which excludes inventory. In some businesses, it may take many months to sell inventory. Here is the adjusted asset number you use for the quick ratio:
$8,815,000 current assets – $3,450,000 inventory = $5,365,000 assets for quick ratio
You compute the quick ratio as follows:
$5,365,000 assets for quick ratio / $4,030,000 current liabilities = 1.3 quick ratio
Wrapping up with working capital
The same data used to calculate current and quick ratios is used to compute working capital. Here’s the formula:
Working capital = Current assets – Current liabilities
A current ratio of at least 1.0 is considered reasonable for liquidity purposes. That’s because the ratio displays at least $1 in current assets for each dollar of current liabilities.
Assume that current assets and current liabilities each total $1,500,000. The current ratio is 1.0 ($1,500,000 / $1,500,000) Put the same data in the working capital formula. Working capital would be zero ($1,500,000 less $1,500,000). Negative working capital would mean that current assets are less than current liabilities. So, the minimum expectation of 1.0 for a current ratio is the same as a $0 working capital calculation.