Investing in the stock markets involves a fair deal of risks. That is why it is very crucial to select the right stocks and keep invested in them for appropriate time frames. However, selecting the right stocks for investment may not be as straightforward as it seems.
Published on 09 June 2022
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You can use various techniques to make future speculations about stock and decide whether you should invest in it.
One such technique that can help you choose the right stock is the fundamental analysis of the company. This technique involves the use of various formulas, ratios, and estimations to evaluate a company’s overall fundamental strength. And liquidity ratios, including the current ratio and the quick ratio, can help a lot when it comes to the fundamental analysis of a company.
These ratios help you evaluate whether a company can meet its debt obligations on time or not. As a golden rule, you should prefer to invest your money in the stocks of companies having high liquidity ratios as they tend to be fundamentally stronger than others. Let’s learn about the current ratio and quick ratio, the formulas for calculating them, and the differences between them.
What is the Current Ratio of a Company?
The current ratio of a company is a liquidity ratio that measures its capability to clear all its liabilities using its current assets. The current liabilities of a company may include all its short-term debts and payables, and the current assets of a company may include all its assets that can be converted into liquid cash in case the need arises.
Examples of current liabilities of a company include:
Short-term debts
Accounts payables
Accrued liabilities
The examples of current assets of a company include:
Cash-in-hand
Accounts receivables
Marketable securities
Prepaid expenses
Inventory
Equipment
Accrued properties
How to Calculate the Current Ratio?
To calculate the current ratio of a company, you can simply divide the cumulative value of its current assets by its current liabilities. The formula for calculating the current ratio of a company is as follows:
Current Ratio = Current Assets of the company / Current Liabilities of the company
So, if a company’s current ratio is less than 1, it means that the cumulative value of its current liabilities is greater than its current assets. This implies that a company is at financial risk as it might not be able to clear its current liabilities using its current assets in case the need arises. Investing in the stocks of such companies can also be a risky thing. Also Read about Cumulative Preference Shares
Similarly, if the current ratio of a company is more than 1, it means that the cumulative value of its current liabilities is lower than its current assets. This implies lower financial risks as the company can liquidate its assets to clear its current liabilities if the need arises. Such companies are considered fundamentally strong companies, and hence, investing in their stocks involves lower risks.
What is the Quick Ratio of a Company?
Just like the current ratio, the quick ratio of a company also measures its liquidity. It determines the capability of a company to pay off its current liabilities by liquidating its current assets. You might be thinking then, what is the difference between the quick ratio and current ratio. While both these liquidity ratios might look eerily similar, they are a bit different from each other.
The quick ratio is a more conservative method of measuring a company’s liquidity as it takes into consideration only those assets that can be liquidated into cash in less than 90 days. So, the current assets in the case of the quick ratio are cash-in-hand, short-term investments, and accounts receivables. The quick ratio of a company is also referred to as its acid-test ratio.
How to Calculate the Quick Ratio?
Below is the formula for calculating the quick ratio of a company:
Quick Ratio = (cash + cash equivalent + current receivables + short-term investments) / current liabilities
As you can see, if the quick ratio of a company is more than 1, it means the company is capable of clearing all its current liabilities by liquidating its current assets. A quick ratio of less than 1 might imply that the company is unable to clear its current liabilities using its current assets in case the need arises.
Current Ratio and Quick Ratio: What's the Difference
Now that you know about the two liquidity ratios, let’s have a glance at the differences between the current ratio and the quick ratio:
Current Ratio
Quick Ratio
A more relaxed method to determine a company’s liquidity
A more conservative and stringent method to determine a company’s liquidity
It includes all current assets of a company
It includes only those assets that can be liquidated within 90 days
It includes the inventories and properties owned by a company
It includes only cash-in-hand, accounts receivables, and short-term investments
The preferable current ratio is 2:1
The preferable quick ratio is 1:1
It measures the ability of a company to meet its current obligations in the long-term
It measures the ability of a company to meet any emergency obligations
To Conclude
As an investor, you should always check the current ratio and quick ratio of a company before deciding to invest in its stocks. Although both these liquidity ratios appear similar, there are plenty of differences between them.
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While the current ratio of a company measures its ability to clear its current liabilities using its current assets in the long run, the quick ratio measures its ability to meet an emergency. Ideally, you should use both the current ratio and quick ratio to determine the fundamentals of a company.
The liquidity ratios measure the current liquidity of a company, i.e., its capability to meet all current obligations by liquidating its current assets. The two most common kinds of liquidity ratios are the current ratio and quick ratio (also known as the acid-test ratio).
Both the current ratio and quick ratio helps in determining whether a company is financially capable of clearing all its current liabilities or not. If the value of these ratios is more than 1, it denotes a fundamentally strong company. On the other hand, companies whose liquidity ratios are less than 1 are said to be fundamentally weak or financially risky companies.
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While the current ratio of a company measures its ability to clear its current liabilities using its current assets in the long run, the quick ratio measures its ability to meet an emergency. Ideally, you should use both the current ratio and quick ratio to determine the fundamentals of a company.
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