When running a business, you need to be able to look at your finances at a glance and see how things are going financially. The quick ratio and current ratio are two commonly used metrics by business owners to keep an eye on their liquidity, or their ability to quickly pay off outstanding liabilities. The two ratio formulas are very similar—the only difference being their treatment of inventory.
Using these formulas, with numbers that you’ll get straight from your balance sheet, it is easy to check in on how your business is doing, if you need to change something, or if you’re in a strong position to invest some money back in the business.
The current ratio, also called the “working capital” ratio, is mostly used to make sure a company is able to pay off short-term debts. These can be things like electricity, bills, payroll, etc. Basically, any bills or payments that will be coming up in the near future.
Current Ratio Formula
When you receive your balance sheet after the month-end close, you will pull the numbers from the current assets and current liabilities sections and input them into this formula to find your current ratio.
Current Ratio = Current Assets / Current Liabilities
The numbers in this formula come straight from your balance sheet, where the assets are listed from top to bottom in order of how easily liquidated that asset is. For example, cash will be at the top, followed by outstanding invoices, and finally property and other fixed assets at the bottom.
The quick ratio, also called the “acid-test” ratio, is also used to look at a company’s financial health and liquidity but also includes the company’s inventory in the formula. Some business owners may not prefer this ratio since there is no way to tell how long it will take a company to get rid of the inventory they currently have on hand. And, of course, some businesses don’t carry inventory at all, like service-based organizations.
Quick Ratio Formula
Calculating this is similar to the current ratio formula, though taking inventory out of the mix. Inventory can also be found on your balance sheet within the assets category.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
The reasoning behind taking out your inventory on hand is because it is not considered a “quick asset,” meaning there is no way of telling exactly when your inventory will be liquidated. Whereas, a quick asset can be described as any asset that can be liquidated within 90 days.
The 3 accounting metrics you need to know
The right numbers make all the difference.
What Is A Healthy Current Ratio? Quick Ratio?
For both of these formulas, it is healthy to have a ratio of at least 1 or larger. Not all businesses need both ratios, which makes sense since some businesses don’t have inventory at all. But those that do carry inventory may not choose to calculate their quick ratio as often—or may do so when they’re in a pinch financially.
These healthy metrics indicate that a business is able to meet all upcoming financial obligations such as bills, payroll, etc. using only current assets (and by potentially selling through inventory).
If a business has a ratio that is higher than 1, the owner may be able to spend more on the business with things such as updating their employees’ tech, hiring new team members, or any other opportunity that could further improve the business.
Example of The Current Ratio and Quick Ratio in Action
Imagine your company is in need of some tech upgrades around the office and you would like to quickly check your finances and make sure that you are in the right place to make those upgrades.
All you need to do is get these numbers from your balance sheet and calculate these ratios:
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 this example, the business owner is able to tell that they will be able to pay off all bills and liabilities without having to immediately liquidate any fixed assets. In the quick ratio, an owner is also able to see that, with inventory accounted for, the business has a large amount of assets that may be able to be used for company wide improvements.
While a ratio of 1:1 is expected in most cases, the average healthy ratio can differ depending on what the expectations are in a particular industry.
Who Reviews the Quick Ratio and Current Ratio?
These ratios can be used for many reasons by different groups of people, like:
- An investor may use these ratios to see if a business is worth investing in. They may help investors determine how well your business manages its finances and whether they can hope for a return.
- Creditors want to ensure they will get repaid for loans, so they will look at these ratios when deciding how much to lend a business so they will be paid back in a timely manner.
- Business owners may use this formula at any point to check on the financial health and liquidity of their company.
How Often Should These Ratios Be Calculated?
A business owner may use the current ratio formula to check if they are able to pay off all of their bills and payroll for the next month or they may use the quick ratio formula to check if they are able to pay off all loans and liabilities for the next year.
Since these metrics rely on the balance sheet, they can be calculated as often as a business produces their financial reports, although we recommend a financial checkup at least once a month. Financial statements are intended to be finalized reports on what happened in the previous month or quarter, which makes them difficult to produce more frequently. That said, if your business produces financial statements only once a year at tax time, that’s likely not enough to keep an accurate pulse on the state of your business.
Learn more about how ScaleFactor can help you keep an eye on the metrics that matter most to your business. Speak with an expert and request a short demonstration today.