In order for a small business to survive, they must be able to anticipate and meet both short and long-term liabilities. In particular, short-term liabilities place more immediate stress on a business’s liquidity and ability to repay debts. As a result, small business owners need to be aware of the importance of their liquidity and use appropriate means to measure their business’s financial condition.
To accurately measure your business’s financial health, it is vital to understand the different types of assets your business holds as the composition of assets essentially determine the overall value of your current assets. If the majority of a company’s assets are staked in cash, collectible accounts receivable, and marketable securities, this is an encouraging sign of liquidity in the company.
However, if a majority of a small business’s assets are staked in uncollectable accounts receivable and slow-moving inventory, this may be an indicator that the business’s assets may not be available to cover liabilities in the short term.
Why are these ratios important?
Current and quick ratios are both intended to estimate a business’s liquidity and ultimately, their ability to pay for its outstanding liabilities by taking into account the composition of your assets. This is important as evidence suggests that these ratios may be able to detect impending financial difficulties for small businesses as early as five years before a business ultimately fails.
Knowing the means of calculation and implicit differences between these two ratios is necessary to conducting a proper analysis of your business’s financial condition.
How are they different from each other?
Quick ratios differ from current ratios as some current assets are specifically excluded from quick ratios, but are included in current ratio calculations. Broadly, the quick ratio focuses on a business’s immediate liquid assets to determine a company’s ability to quickly pay off its obligations.
The primary difference between these two ratios is the inclusion or non-inclusion of inventory. Inventory is a particularly questionable item to factor in the analysis of a small business’s liquidity as it is notoriously difficult to convert to cash quickly. Furthermore, inventory complicates liquidity analysis if it is sold on credit, as the business must wait until the purchaser pays for the service or item sold.
As a result, a more reliable measure of a business’s short-term liquidity is the quick ratio. However, current ratio may be an accurate measurement of liquidity if you run a small business with high inventory turnover such as a grocery store. Current ratios are fairly accurate for these small businesses as inventory is sold quickly and the sales are converted to cash rapidly.
How do you calculate current or quick ratios?
Turning to the methods of calculating these ratios:
- Formula for current ratio : (Cash + Accounts Receivable + Marketable securities + Inventory) / Current liabilities.
- Formula for quick ratio : (Cash + Accounts Receivable + Marketable securities) / Current liabilities.
For instance, if a particular company has current assets worth approximately $800,000 and current liabilities totaling $200,000, the company’s current ratio is 4:1. This is generally seen as a strong current ratio and indicates strong liquidity for the company.
Inversely, if a company has current assets worth approximately $200,000 and its current liabilities are $600,000, the company’s current ratio is 1:3. The latter example indicates insolvency as many experts contend a current ratio less than 1:1 is an indicator of a struggling business and potential insolvency.
In a quick ratio example, if your small business has total assets of $600,000 in cash + accounts receivable + marketable securities and current liabilities totaling $800,000, its quick ratio is 0.75:1. This is calculated as the current assets divided by current liabilities, or ($600,000 divided by $800,000 = 0.75). Like the current ratio, a higher quick ratio is an indicator of greater liquidity for a business. In the given example, a business with a 0.75:1 quick ratio is likely experiencing liquidity issues and likely will not be able to quickly pay off its current liabilities if necessary.
What else should I keep in mind?
Finally, it is important to note that your small business’s current ratio and quick ratio should be analyzed with ratios of other businesses in the same respective industry. When comparing your ratios against another business’s ratios, it would be prudent to look at the trends over time. This helps in analyzing the current state of other small businesses within the respective industry as an improving ratio over time may be an indicator of better financial decisions within the company and/or overall market growth in the respective industry.