Welcome to Alanis Business Academy. I’m Matt
Alanis and this is How to Calculate a Current and Quick Ratio. Both the current and quick ratios use information
off of the balance sheet to measure the liquidity of a firm. With these ratios, we’re attempting
to gauge whether or not the firm could cover its short-term obligations if the firm were
to experience cash flow problems. For an in-depth overview of the balance sheet click the link
above or go to the Alanis Business Academy YouTube channel page and search under the
playlist labeled Accounting for the video titled The Balance Sheet Part 1. In short, the current and quick ratios help
us evaluate whether or not a firm has enough current assets, meaning assets that are cash
or can be converted to cash within a year, to meet its short-term debt obligations. These
short-term debt obligations are known as current liabilities, and they include any liabilities
that will become due within one year. Common current assets include cash, cash equivalents,
accounts receivable, inventories, as well as other short-term investments. Common current
liabilities include things like accounts payable, wages payable, interest payable, as well as
other short-term debt obligations. Now that we’ve discussed the basic elements
of both ratios lets walk through how to actually calculate them. Lets start with the current
ratio. To calculate the current ratio you first need to determine the amount of a firms
current assets and current liabilities. These are commonly reported in total on a firms
balance sheet as separate entries. Once you’ve located both current assets and current liabilities,
divide the firm’s current assets by its current liabilities. As an example, lets say that
we have $3,000 in current assets with $1,500 in current liabilities. After dividing our
$3,000 in current assets by our $1,500 in current liabilities we would be left with
a current ratio of 2.0. This means that we have twice as many current assets as current
liabilities, but is this a good thing? Although a current ratio of 2.0 is considered adequate
for most industries you’ll want to look at what is common for the industry. A current
ratio of 2.0 may be great for some industries, but it may be dangerously low for others. The quick ratio is almost identical to the
current ratio, however it attempts to solve one dangerous assumption that the current
ratio makes. Is it reasonable for a firm to assume that it will be able to convert all
of its inventory into cash within the next year? Unfortunately it isn’t. The truth is
that inventory becomes obsolete quickly, especially for technology goods. Inventory also becomes
damaged, stolen, and often just sits on store shelves. This assumption can be particularly
harmful for a retailer, which often carries a large percentage of its current assets in
inventory due to the very nature of its business. In order to take a more conservative approach
to gauging the liquidity of a firm we use the quick ratio. In order to calculate the
quick ratio we still gather the current assets and the current liabilities of a firm, but
prior to our calculations we deduct inventories from current assets. That way we’re not assuming
a firms inventory will be there to assist in covering their current liabilities. Now
truthfully some inventory, maybe even a large percentage of it, will be sold. However, just
in case it doesn’t we’re prepared. Continuing our example above lets say that
we still have $3,000 in current assets and $1,500 in current liabilities. We also have
$2,000 in inventory. Factoring out our inventory we now only have $1,000 in current assets
and we still have $1,500 in current liabilities. After dividing our remaining current assets
by our current liabilities we’re left with a quick ratio of 0.67 rounding to the nearest
hundredth. Unfortunately in this example we don’t have enough current assets less inventory
to cover our short-term debt obligations. Generally a quick ratio of 1.0 is adequate,
so you could say that we have some liquidity issues given our current financial position.
Once again though, researching the industry average will help us get a more accurate gauge
on what is an acceptable quick ratio. This has been How to Calculate a Current and
Quick Ratio. For access to business videos be sure to subscribe to Alanis Business Academy
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