Welcome to Alanis Business Academy.
I'm Matt Alanis and this is How to Calculate a Current and Quick Ratio.
Both the current and quick ratios use information off of the balance sheet to measure the liquidity
of a firm.
With these ratios, we're attempting to gauge whether or not the firm could cover its short-term
obligations if the firm were to experience cash flow problems.
For an in-depth overview of the balance sheet click the link above or go to the Alanis Business
Academy YouTube channel page and search under the playlist labeled Accounting for the video
titled The Balance Sheet Part 1.
In short, the current and quick ratios help us evaluate whether or not a firm has enough
current assets, meaning assets that are cash or can be converted to cash within a year,
to meet its short-term debt obligations.
These short-term debt obligations are known as current liabilities, and they include any
liabilities that will become due within one year.
Common current assets include cash, cash equivalents, accounts receivable, inventories, as well
as other short-term investments.
Common current liabilities include things like accounts payable, wages payable, interest
payable, as well as other short-term debt obligations.
Now that we've discussed the basic elements of both ratios lets walk through how to actually
calculate them.
Lets start with the current ratio.
To calculate the current ratio you first need to determine the amount of a firms current
assets and current liabilities.
These are commonly reported in total on a firms balance sheet as separate entries.
Once you've located both current assets and current liabilities, divide the firm's current
assets by its current liabilities.
As an example, lets say that we have $3,000 in current assets with $1,500 in current liabilities.
After dividing our $3,000 in current assets by our $1,500 in current liabilities we would
be left with a current ratio of 2.0.
This means that we have twice as many current assets as current liabilities, but is this
a good thing?
Although a current ratio of 2.0 is considered adequate for most industries you'll want to
look at what is common for the industry.
A current ratio of 2.0 may be great for some industries, but it may be dangerously low
for others.
The quick ratio is almost identical to the current ratio, however it attempts to solve
one dangerous assumption that the current ratio makes.
Is it reasonable for a firm to assume that it will be able to convert all of its inventory
into cash within the next year?
Unfortunately it isn't.
The truth is that inventory becomes obsolete quickly, especially for technology goods.
Inventory also becomes damaged, stolen, and often just sits on store shelves.
This assumption can be particularly harmful for a retailer, which often carries a large
percentage of its current assets in inventory due to the very nature of its business.
In order to take a more conservative approach to gauging the liquidity of a firm we use
the quick ratio.
In order to calculate the quick ratio we still gather the current assets and the current
liabilities of a firm, but prior to our calculations we deduct inventories from current assets.
That way we're not assuming a firms inventory will be there to assist in covering their
current liabilities.
Now truthfully some inventory, maybe even a large percentage of it, will be sold.
However, just in case it doesn't we're prepared.
Continuing our example above lets say that we still have $3,000 in current assets and
$1,500 in current liabilities.
We also have $2,000 in inventory.
Factoring out our inventory we now only have $1,000 in current assets and we still have
$1,500 in current liabilities.
After dividing our remaining current assets by our current liabilities we're left with
a quick ratio of 0.67 rounding to the nearest hundredth.
Unfortunately in this example we don't have enough current assets less inventory to cover
our short-term debt obligations.
Generally a quick ratio of 1.0 is adequate, so you could say that we have some liquidity
issues given our current financial position.
Once again though, researching the industry average will help us get a more accurate gauge
on what is an acceptable quick ratio.
This has been How to Calculate a Current and Quick Ratio.
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