Understanding Current Ratio and Quick Ratio

Current Ratio

 

While the Debt-Equity ratio is focussed on the overall leverage of the company, the Current Ratio (and its cousin Quick Ratio) focuses on short term liquidity. It is a solvency ratio, in the sense that it tries to find out if the company has enough liquidity to meet its current liabilities. It tells us if the company will remain solvent or may face the liquidity crisis.

The current ratio is easy to compute and understand. It is obtained by taking the figures of current assets and current liabilities from the balance sheet. In simple terms, if the current assets are more than the current liabilities, the company has enough short term resources to pay off the immediate obligations. A ratio of less than one, that is, current assets being less than current liabilities, is a definite cause of concern, and the company must find sources of finance to meet its liabilities.

Let us define here the components that make the current ratio.

 

  1. Current Assets: Current assets are to be found in the balance sheet and consist of the following:
  2. Cash and cash equivalents
  3. Marketable securities
  • Debtors
  1. Prepaid expenses
  2. Inventory

 

As you can see, these are the assets which would get converted into cash in a few days or months, hence the name ‘current’. These assets have an interesting characteristic. They ‘circulate’. When inventory is sold out, you realise either cash, or a right to receive money- the debtors, when cash is realised from the debtors it gets converted into ‘cash or cash equivalents’; and is ready for another cycle.

 

Inventory => Debtors => Cash

 

  1. Current Liabilities: Current liabilities and short term liabilities and obligations payable by the company within one year. This can be easily located under the head, “Current Liabilities and Provisions” in the balance sheet. It consists of the following:
  2. Short-term debt
  3. Accounts payables
  • Accrued liabilities and other debts

 

 

Now that we have defined the components, let us define the ratio

 

 

CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES

 

Let us take one example.

 

 

Following are the Current Assets of Pidilite Industries as on 31st March 2018

 

CURRENT ASSETS (Rs crore)
Current Investments 1,072.01
Inventories 630.94
Trade Receivables 689.59
Cash And Cash Equivalents 77.76
Short Term Loans And Advances 13.22
Other Current Assets 180.02
Total Current Assets 2,663.54

 

The following are the Current Liabilities of the company as on 31st March 2018

 

 

CURRENT LIABILITIES (Rs crore)
Short Term Borrowings 0
Trade Payables 428.16
Other Current Liabilities 450.6
Short Term Provisions 9.78
Total Current Liabilities 888.54

 

Both the charts are a part of the balance sheet of the company, and I have not taken any special effort to cull them.Contrary to what people think, most of the information are easily available, you just need to be willing to use them.

 

The Current Ratio =2663 / 888 = 3

(fractions ignored or rounded off for the sake of simplicity)

 

What does the ratio mean? It tells us that for every one rupee of short term liability of the company, the company has resources worth Rs 3. Theoretically speaking, if all the money’s worth Rs 888 crore became due tomorrow, the company can sell off a portion of current assets worth Rs 2663 crore and meet the obligation.

 

A few words of caution:

As discussed for other ratios, the current ratio might be different for different industries, and works better as a tool of comparison with peers or with the industry average. Comparing two companies belonging to different sectors may not be meaningful.

With the advent of just in time management techniques, modern manufacturing companies have managed to reduce the size of buffer inventory thereby leading to significant reduction in working capital investment and hence lower current ratios.

In some industries, current ratio of lower than 1 might also be considered acceptable. This is especially true of the retail sector and companies like Big Bazaar and D-Mart. This primarily stems from the fact that such retailers are able to negotiate long credit periods with suppliers while offering little credit to customers leading to higher trade payables as compared with trade receivables. Such retailers are also able to keep their own inventory volumes to minimum through efficient supply chain management.

 

While a very high current ratio may be good from the point of meeting the obligations, it would be wrong to presume higher the better. Too high a ratio may mean inefficient utilisation of resources, which may be fine from liquidity perspective but may pull the profits down.

Finally, sometimes the ratio may mislead and give a false sense of confidence. Consider the case of Pidilite Industries. As you can see, some of the current assets are more current than the others. Cash is the most liquid of all, current investments are a short term application of cash, and can be converted into cash in a day. Stock has a long cycle of conversion. Some of the stock may not realise anything (’dead stock’), some debtors may be sticky, and some bad; when you try to realise them you may face the hurdle. In this case, the quickly realisable current assets (cash and current investments) are sufficient to meet the liabilities. In some companies, while it may look like a healthy ratio, company may still struggle to meet day to day obligations.

This leads us to a further refinement of ratio, the Quick Ratio.

 

 

Quick Ratio

 

Quick ratio is more conservative than current ratio, and gives better view of short term solvency of the company. Not all current assets are realisable quickly, converting inventory into cash is a long process, and this ratio ignores the less liquid of the current assets, and considers only fast converting assets. Because this ratio is more accurate and conservative, it is also known as the ‘Acid Test Ratio’.

 

The formula is

 

Quick Ratio = Quick Assets / Current Liabilities.

 

The denominator current liabilities remains same as in the equation of current ratio, only the numerator changes to a lower figure.

 

Quick Assets (Also known as liquid assets) are:

  1. Cash and Equivalents
  2. Marketable Securities
  • Accounts Receivable

 

Using the data for Pidilite Industries, let us calculate the Quick Ratio

 

 

Quick Assets (1072+689+77) = Rs 1838 crores (Fractions ignored)

Current Liabilities = Rs 888 crores

 

Quick Ratio = 1838 / 888 = 2

 

Quick Ratio of 2 may be considered exceptionally good in terms of solvency of the company.

 

 

©Dr. Tejinder Singh Rawal

Chartered Accountant

M. Com, MA (Economics), MA (Public Administration), MA (Urdu), LLB, FCA, ISA, CISA, CISM, PhD

This content is copyrighted and no part of it may be reproduced without the consent of the author

 This discussion will be a part of the forthcoming book by me “The Smart Long Term Investor: Common Sense Strategies for Wealth Creation” Suggestions are welcome and will be appreciated

 

 

This Post Has 2 Comments

  1. Your recent blogs have made me revise all that I learnt in +2 and graduation . Honestly ,now I actually understand how important that bookish knowledge imparted then is now vis a vis investing my money in stocks.

    1. Thanks a lot 🙂

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