fbpx

April 14, 2022

If you’re like most people, you’ve probably heard of the terms “current ratio” and “quick ratio” but don’t know what they mean. Current ratio vs quick ratio are two ratios that are important indicators of a company’s financial health, so it’s worth taking the time to understand them.

The current ratio is the ratio of a firm’s current assets and current liability. The quick ratio is the ratio of its liquid (quick) assets and current debt. So which one should you focus on between current ratio vs quick ratio?

Current Ratio vs Quick Ratio

Both the current and quick ratios give the same picture of the company’s ability to meet its obligations but do so with differing periods.

The current ratio shows a company’s ability to pay its short-term obligations with its current assets. The quick ratio shows a company’s liquidity based only on assets that are convertible to cash within 90 days.

The difference between the current ratio and the quick ratio is that the quick ratio only considers assets that can be quickly converted into cash, while the current ratio considers assets that take more time to liquidate.

Liquidity ratios are an important tool for measuring how a company can pay off its debt. The most common liquidity ratios used are the current ratio and the quick ratio.

These financial metrics can help investors or lenders assess a company’s financial stability. Generally speaking, a low liquidity ratio is a sign that the company is in crisis.

On the other hand, a high liquidity ratio can mean that a company is focusing on liquidity and is not effectively using its capital to expand its business.

What is the Current Ratio?

The current ratio equals current assets divided by current liabilities. In accounting, “current” means one year or less.

In short, a current liability is a debt that is due within a year. A current asset is an asset that can convert into cash in less than a year.

Bank accounts and accounts receivable are current assets. Accounts payable and payroll liabilities are current liabilities.

Ideally, the current ratio of a company should be above 1. Companies with a current ratio below 1 are considered riskier because they don’t have enough cash to pay their current debts.

A low current ratio shows that the company probably won’t be able to pay its short-term obligations.

Companies with a ratio of 1 or higher are less risky because their assets exceed their liabilities. Therefore, it should be possible to liquidate current assets to pay off short-term debts (liabilities).

What is a Quick Ratio?

The quick ratio is a measure of a company’s liquidity. It is calculated by summing up the cash, receivables, and investments of the company and dividing it by its short-term debt.

This metric is considered conservative since it uses actual cash and other specific assets to calculate the numerator.

The quick ratio is also called the “acid test” ratio since it calculates the most liquid of the current assets that can be converted to cash within 90 days or less.

Current Ratio vs Quick Ratio: Similarities and Differences

The common denomination in both ratios is the current liabilities. They also both use current accounts in the calculation.

Their main difference is the type of assets included. The quick ratio is based only on specific, designated, and existing assets while the current ratio includes all current assets. Both ratios should be above 1, but they each reflect a different concept.

A current ratio of 1 means that a company can cover its expenses, but it might have to liquidate some of its assets to do so. A quick ratio of 1 means that a company has sufficient liquid funds to cover its short-term debts.

Both current and quick ratios are important as investors and lenders use them to gauge a company’s financial health.

As a business, it’s important to understand how different business decisions can affect your cash flows, your ability for financing, and your options for capital.

A Certified Public Accountant (CPA) can provide advice regarding key business metrics, such as the current and quick ratios of your company.

Calculating SaaS Quick Ratio to Track and Reduce Customer Churn

SaaS companies have a unique way of calculating quick ratios because their revenue model is subscription-based. This means that assets and liabilities are viewed from a different perspective, which is reflected in their financial analysis.

The quick ratio formula is not relevant to the SaaS sector because the SaaS industry computes variables differently from conventional businesses.

SaaS Quick Ratio = (New MRR + Expansion MRR + Reactivation MRR) ÷ (Contraction MRR + Churn MRR).

Let’s look at an example of a SaaS financial statement.

New MRR: $200,000

Reactivation MRR: $150,000

Expansion MRR: 175,000

Churned MRR: $90,000

SaaS quick ratio = ($200,000 + $150,000 + $175,000) / $90,000 = 5.8.

From these numbers, it’s clear that the company is doing very well. The monthly recurring revenue (MRR) is steadily increasing and the churn is low. However, the SaaS quick ratio gives a different perspective.

SaaS quick ratio is a helpful KPI for measuring business growth and pinpointing areas that may need improving. 

If your SaaS quick ratio is:

  • Less than 1: You may not survive the next two months.
  • Between 1 to 4: Growth is sluggish and you might run into cash flow problems if the MRR does not improve.
  • Over 4: Growth is excellent and you’re earning four times every dollar you lose.

From the example earlier, we can see that the company is generating $5.8 for every $1 it loses or fails to retain.

How Often Should You Calculate Ratios?

As a small business owner, you can calculate your current and quick ratios to determine if you have sufficient cash reserves to pay your upcoming bills and salaries.

Although you can calculate these ratios using information from your balance sheet, we recommend doing a financial checkup at least once a month. This way, you can keep tabs on your company’s financial health and make sure that you’re on track to meet your goals.

Monthly or quarterly financial statements are reports intended to give an overview of a company’s financial standing. These reports are difficult to regularly produce more frequently.

However, if your company only issues financial reports annually, that’s not enough data for you to accurately assess the health of the company.

What Is A Healthy Current Ratio and Quick Ratio?

For both of these metrics, a healthy ratio to have is 1 or higher. Not all businesses have both, which makes perfect sense. After all, some businesses don’t have any physical products at all.

But companies that do sell their product may not check their quick ratio as often, or they might do it when money gets tighter.

These strong financials show that a company can meet all of its obligations (salary, rent, bills, etc) using its current assets or by selling assets.

A business is deemed to be in good health when both ratios are above 1. This means that it has sufficient cash reserves to pay all of its current debts. The importance of the Quick Ratio is that it indicates whether a business has enough money on hand to pay for all of its immediate expenses, such as paying its suppliers.

If a business has a ratio higher than 1, it can increase its spending with things like employee training, new equipment, and new hires.

More Examples of Current Ratio and Quick Ratio

Let’s say your company needs tech upgrades around the office and you would like to quickly check your finances if you can afford them. Here are the figures that you need to get from your balance sheet.

Calculating these simple accounting figures is all it takes to figure out your profit margins.

Current assets = $5 million

Inventory = $2 million

Current liabilities = $2 million

Loans = $1 million

Current ratio: $5 Million / ($2 Million + $1 Million) = 1.6

Quick ratio: ($5 Million – $2 Million) / ($2 Million + $1 Million) = 1

Using these sample figures, you know you can pay off all company obligations without having to sell any of your assets.

In the quick ratio, with your inventory taken into account, you know that you have enough assets to make company-wide changes.

While a 1:1 ratio is normal, the average healthy ratio can vary based on the expectations of a particular business.

Who Uses These Metrics?

These ratios are used by many different types of people for different reasons.

  • Investors. Before an investor agrees to fund your company, they might want to see these ratios to determine how well your business manages its finances and if the investment is worth it.
  • Creditors. Lenders want to make sure you can pay your debt so they will look at these ratios before approving your loan.
  • Business owners. You may use this formula to check the financial health and liquidity of your company at any time.

Conclusion

Current ratio vs quick ratio: which metric should you use? Both are considered good metrics to determine the financial health of a company. However, the quick ratio is generally considered to be a more accurate measure of a company’s ability to meet its short-term obligations. Therefore, if you’re trying to choose between the two ratios, it may be best to focus on the quick ratio.

You may also like…

0 Comments

Submit a Comment

Your email address will not be published. Required fields are marked *

%d bloggers like this: