Liquidity ratios measure a firm’s ability to meet its short term obligations. Current ratio and quick ratio are the most frequently used ratios for measuring a firm’s liquidity position. It is frequently said that a current ratio of 2:1 and a quick ratio of 1:1 is optimum for a company.

In order to calculate current ratio and acid test ratio (quick ratio) we need to understand the components of current assets, quick assets and current liabilities.

Components of Current assets, Quick assets and Current liabilities

Current Assets

Current assets include cash, inventory, accounts receivables, short term investments and prepaid expenses. These assets are called current assets because they are expected to be converted into cash within a short period of time (such as one year). Hence, any investment which has a maturity period of more than one year will not be treated as current assets.

Quick Assets

Quick assets include cash, accounts receivables and short term investments. Inventory and prepaid expenses are not included while calculating total quick assets. Inventory is excluded from the calculation of current ratio because it may not be possible to convert inventory into cash as quickly as other assets. Similarly prepaid expenses are excluded because such expenses have already been incurred by the company. It is important to note that prepaid expenses cannot be exchanged for cash.

Current Liabilities

Current Liabilities include accounts payables and short term outstanding liabilities. Information on current liabilities is available on the liability side of balance sheet. It is important to note that current liabilities are expected to be settled within a period one year. Hence, any amount of debt which has a payment period of more than one year will not be considered as a current liability.

Formula for Calculating Current Ratio and Quick Ratio is as follows:

Current Ratio

Current Assets/Current Liabilities

Quick Ratio

(Current Assets – Inventory – Prepaid Expenses)/Current Liabilities or (Cash + Accounts Receivables + Short term investments)/Current Liabilities

Information for calculating current ratio and quick ratio is available in the balance sheet of any company.

Calculation of Current and Quick Ratio

Let us understand the calculation of these two liquidity ratios with the help of an example.

Following information is available from the balance sheet of XYZ Ltd.
Land and Building $ 85,000, Plant and Machinery $ 75,000, Cash in hand $ 10,000,
Cash at bank $ 40,000, Inventory $ 30,000, Sundry Debtors $ 90,000, Sundry Creditors $ 70,000, Outstanding rent $ 30,000, Prepaid Expenses: $ 5,000.

With the help of above mentioned figures, current ratio and quick ratio can be calculated as follows:

Total Current Assets = $ 10,000 (Cash in hand) + $ 40,000 (Cash at bank) + $ 30,000 (Inventory) + $ 90,000(Sundry Debtors) + $ 5,000 (Prepaid Expenses) = $ 1, 75,000

Total Quick Assets = $ 10,000 (Cash in hand) + $ 40,000 (Cash at bank) + $ 90,000 (Sundry Debtors) = $ 1, 40,000

Total Current Liabilities = $ 70,000 (Sundry Creditors) + $ 30,000 (Outstanding Rent) = $ 1, 00,000

Current Ratio = $ 1, 75,000 (Total Current Assets)/$ 1, 00,000 (Total Current Liabilities) = 1.75:1

Quick Ratio = $ 1, 40,000 (Total Quick Assets)/ $ 1, 00,000 (Total Current Liabilities) = 1.4:1

A decrease in the value of any current liability would generally lead to a corresponding reduction in the value of a current asset. For Instance, a payment of $ 10,000 to a sundry creditor in the above example would result in a reduction of $ 10,000 in the cash balance of the company. As a result, cash in hand will come down to zero while sundry creditors would come down to $ 60,000. Total current assets would come down to $ 1, 65,000 while total current liabilities would come down to $ 90,000. Quick assets will come down to $ 1, 30,000. Current ratio and quick ratio would be 1.83 and 1.44 respectively.