Before getting into the topic Quick ratio vs current ratio let me start off by giving a small introduction about Liquidity ratios.
The term “liquidity” refers to readily convertible into cash or money.
Liquidity ratios are basically used to measure how liquid the assets are to pay off company’s liabilities. It usually indicates the position of the company that it can actually set off its liabilities part with the available liquid assets.
So this liquidity ratio is considered as an important tool to analyze the financial position of the company and plays a crucial role while evaluating the financial statements (Balance Sheet). A liquidity ratio is the part of ratio analysis and comes under “Solvency ratios”. Again it is divided into three such as
- Current ratio
- Quick ratio or Acid test ratio
- Cash ratios
As we discussed earlier current ratio is the exact relation between both current assets and current liabilities. I would explain about the solvency position of an entity by paying off its short-term debts with the readily convertible assets (Current assets).
For an example, if a company is having Rs.200, 000 (Includes inventory Rs. 50,000) worth of current assets and Rs.100, 000 worth of current liabilities, what would be the current ratio?
Here we can see the formula for the calculation of current ratio.
Current ratio = Current assets (Includes Inventory) / Current Liabilities
So, Current ratio is 200,000/100,000 = Rs.2
Hence, we can say that company is in a position to pay off each one rupee of liability with an amount of Rs.2 current asset. The ultimate object is to find the liquidity position to set off company’s short-term debts with liquid assets.
Quick ratio: It is similar to the calculation of current ratio but in order to find out the immediate liquidity ( i.e settling the liability with readily available liquid assets) we need to exclude the long-term liquid assets. That is the reason why inventory is not considered as an immediate selling asset because it will take bit more time to convert into money.
Here we can see the formula for quick ratio.
Quick ratio = Current Assets – Inventory / Current Liabilities – Bank OD
So here the quick ratio is 200,000-50,000 / 100,000 = Rs.1.5
Here the value is different from the above one. We can say that company is in a position to pay off each one rupee of liability with an amount of Rs.1.5 current asset.
End of the discussion that is the reason why companies used to exclude the Inventory part while performing the quick ratio function.
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