The formulas
- Current ratio = current assets ÷ current liabilities
- Quick ratio (acid-test ratio) = (cash + short-term investments + receivables) ÷ current liabilities
- Cash ratio = (cash + short-term investments) ÷ current liabilities
- Working capital = current assets − current liabilities, an amount rather than a ratio
The quick ratio leaves out inventory and prepaid expenses. Inventory has to be sold, and often sold on credit, before it becomes cash. Prepaid expenses, such as rent paid in advance, never turn into cash at all. You will also see the quick ratio written as (current assets − inventory − prepaid expenses) ÷ current liabilities, which gives the same result when those are the only other current assets.
Same current ratio, different story
Both companies have $800k of current assets against $400k of current liabilities, a current ratio of 2.00 and the same $400k of working capital. On that measure they are equally safe.
The quick ratio separates them. The retailer's current assets are mostly stock: $560k of its $800k. Without it, the quick ratio falls to 0.50, so cash and receivables cover only half of what it owes in the next twelve months. The software firm has almost no inventory, and its quick ratio is 1.80. If both had to pay all their current liabilities tomorrow, only the software firm could do it without selling anything.
Worked example: two companies, one current ratio
Figures in $ thousands. Both companies have exactly the same current assets and current liabilities in total.
| A | B | C | Formula in B | |
|---|---|---|---|---|
| 1 | $ thousands | Retailer | Software firm | |
| 2 | Cash | 120 | 300 | |
| 3 | Accounts receivable | 80 | 420 | |
| 4 | Inventory | 560 | 20 | |
| 5 | Prepaid expenses | 40 | 60 | |
| 6 | Current assets | 800 | 800 | =SUM(B2:B5) |
| 7 | Current liabilities | 400 | 400 | |
| 8 | Working capital | 400 | 400 | =B6-B7 |
| 9 | Current ratio | 2.00 | 2.00 | =B6/B7 |
| 10 | Quick ratio | 0.50 | 1.80 | =(B2+B3)/B7 |
| 11 | Cash ratio | 0.30 | 0.75 | =B2/B7 |
Which ratio should you use?
Use both, because they answer slightly different questions. The current ratio shows the overall cushion of short-term assets over short-term debts. The quick ratio is the stress test: what happens if sales stop and the stock cannot be turned into cash quickly. The cash ratio is stricter still and matters most when customers might also pay late.
The gap between the two ratios tells you how much the company depends on its inventory. For the retailer the gap is large, so the question becomes how fast that stock sells. Look at inventory days (DIO) next.
What is a good current ratio and quick ratio?
Common rules of thumb say a current ratio of about 1.5 to 2 and a quick ratio of about 1 are comfortable. Treat these as starting points, not targets. A supermarket that sells its stock in days and is paid in cash can run safely on a quick ratio well below 1. A manufacturer with slow-moving stock may need a higher current ratio. Very high ratios are not automatically good either: they can mean idle cash or too much stock. Compare with the company's own history and with direct competitors.
Ratios are a snapshot, cash flow is the film
Both ratios use balance sheet figures from one day. They say nothing about how fast receivables are collected or how quickly stock sells, and those speeds decide whether the current assets really arrive as cash in time. That is why analysts and lenders read liquidity ratios together with the cash conversion cycle and a cash-flow forecast. A company with a modest quick ratio but customers who pay in 20 days can be safer than one with a high ratio and customers who pay in 90.
Calculating them in Excel
Put each balance sheet item in its own row, build current assets with SUM, and write each ratio as a short formula pointing to those cells, for example =(B2+B3)/B7 for the quick ratio. Format the ratios with two decimals rather than as percentages. A current ratio is usually read as "2.0", not "200%". With the companies side by side in columns, the comparison is one glance.
Common mistakes
- Counting inventory in the quick ratio. Leaving it out is the whole point of the measure.
- Including long-term items, such as a loan repayable in three years, in current liabilities, or long-term investments in current assets.
- Forgetting the current portion of long-term debt. Loan repayments due within twelve months are current liabilities.
- Reading one ratio in isolation. A ratio means little without the trend over several years and a peer comparison.
- Ignoring the balance sheet date. Seasonal businesses can look very liquid or very stretched depending on the month their year ends.
Frequently asked questions
What is the difference between the current ratio and the quick ratio?
The current ratio divides all current assets by current liabilities. The quick ratio uses only cash, short-term investments and receivables, leaving out inventory and prepaid expenses that cannot be turned into cash quickly.
Why is the quick ratio called the acid-test ratio?
The name comes from the old acid test for gold: a strict test of what is real. The quick ratio is a strict test of whether a company can pay its short-term debts without relying on selling inventory.
Can the current ratio be too high?
Yes. A very high current ratio can mean that cash is sitting idle or that inventory and receivables are building up, which ties up money that could be used better elsewhere.
Is a quick ratio below 1 bad?
Not necessarily. Businesses that sell stock quickly for cash, such as supermarkets, often work safely below 1. It is a warning sign mainly for companies whose inventory sells slowly.