The current ratio includes inventory while the quick ratio does not. Both ratios can be used to determine a company’s liquidity, but the choice depends on the company and its inventory value. Tracking both ratios can help determine if inventory is holding at a beneficial level.
The difference between the current ratio and the quick ratio is that the former includes inventory in its equation, while the latter does not. The current ratio measures a company’s liquidity by dividing current assets by current liabilities. The quick ratio does essentially the same thing, but can be used when the inventory attached to the business is of variable value.
Evaluating the long-term value of inventory can help an analyst decide between the current rate and the fast rate as a means of determining the company’s liquidity. There are several reasons why an inventory may not maintain its original sale value. A company may need to lower prices to make enough sales to stay profitable or even stay in business. It may also be necessary to lower prices when there is too much capital tied up in inventory.
When determining liquidity, an analyst can use both the current ratio and the quick ratio. The quick ratio can be used first, to determine that the company has the resources to make the operating costs. So the current ratio could be used to determine actual current liquidity.
Whether to use the current and quick ratio or choose one or the other depends on the company being investigated. For a significant investment, both relationships can be valuable. An analyst who simply wants to know if the company has enough liquid assets to stay afloat may only need the quick ratio. If it has been determined that the inventory value is likely to remain stable, then the current ration will often suffice.
In the long term, tracking both the current ratio and the quick ratio can help an analyst determine if inventory is holding at a beneficial level. The company could have too much inventory if the quick ratio decreases while the current ratio remains stable. In this case, a company would want to improve their relationship quickly. The main ways to approach this are to increase sales or gradually decrease the amount of inventory.
Both the current and quick ratio can be used to determine not only the amount of cash available, but also how it is being used. If the ratios are low, then it is possible that a large part of the company’s cash is used for operating expenses. It is also possible that too many of your resources are tied up in other companies and are not available for operations. If the ratio is too high, the company may not be able to invest its excess cash in companies that increase profits.
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