Current Ratio
The Current Ratio, also known as the working capital ratio, is the ratio between Current Assets and Current Liabilities. It is a measure of the short-term liquidity of a business. Current Assets are those items on a company’s Balance Sheet which they can convert into cash within a year. Current Liabilities are the obligations and debts of a company that they have to pay off within a year.
The ideal ratio here should be equal to or greater than 2:1. It helps companies determine whether their Current Assets are sufficient to pay off the Current Liabilities.
Liquid Ratio
The Liquid Ratio, also known as the quick or acid test ratio, is the ratio between Liquid Assets and Current Liabilities. Liquid Assets are a part of Current Assets, and it includes only those items that a company can convert into cash within 90 days or less. It contains items like cash and cash equivalents, marketable securities and accounts receivable.
The ideal Liquid Ratio for a company should be 1:1 or more, and it indicates that the company can meet its immediate liability obligations through Liquid Assets.
Differences between Current Ratio and Liquid Ratio
Some of the major differences between Current Ratio and Liquid Ratio are as follows:
Current Ratio | Liquid Ratio |
Definition | |
The Current Ratio is the ratio between the Current Assets and the Current Liabilities of a company. | The Liquid Ratio is the ratio between the Liquid Assets and the Current Liabilities of a company. |
Purpose | |
The Current Ratio helps the firm assess its capability to meet any short-term obligations that may arise while conducting business. | The Liquid Ratio helps a firm assess its capability to meet any urgent requirements for cash that may arise while conducting business. |
Current Assets | |
The Current Ratio includes all the Current Assets of the business. | The Liquid Ratio includes only those Current Assets that the firm can liquidate to cash within the next ninety days. |
Inventory | |
The Current Ratio includes the inventory stock of a firm. | The Liquid Ratio excludes the inventory stock of a firm. |
Ideal Ratio | |
Although anything more than 1 is the ideal scenario for a company, a Current Ratio of 2:1 is preferable. | The ideal Liquid Ratio for a company is more than 1. |
Approach for Paying Debt | |
The Current Ratio is a much more relaxed method of finding out whether a company can repay its creditors in case of an emergency. | The Liquid Ratio is a much more stringent method of finding out whether a company can repay its creditors in case of an emergency. |
Comparison | |
The Current Ratio will be naturally higher for a company that has a higher stock of inventory. | The Quick Ratio will be naturally lower for a company that has a higher stock of inventory. |
Conclusion
While it is impossible to analyse a company’s liquidity accurately, these accounting ratios can give us some idea in that direction. There are many differences between the Current Ratio and Liquid Ratio as stated above. But both of them are important to assess the ability of a business to clear off its debts in an emergency. It also helps a firm plan ahead in terms of keeping enough cash reserves for such situations.
Frequently Asked Questions
Q1
Give a list of the items included in the Current Assets while calculating the Current or Liquid Ratio.
The Current Assets include items like cash in hand, trade receivables, cash at the bank, sundry debtors, short-term loans and advances, inventories, prepaid expenses and disposable investments.
Q2
Give a list of the items that are included in the Current Liabilities while calculating the Current or Liquid Ratio.
The Current Liabilities include items like creditors, overdraft, outstanding expenses, short-term loans, proposed dividends, unclaimed dividends, provision for taxes and advances from customers.
Q3
Why is the Liquid Ratio considered to be more conservative compared to the Current Ratio?
The Liquid Ratio includes only the Liquid Current Assets (items that the firm can liquidate within ninety days), while the Current Ratio includes all the Current Assets. It is why Liquid Ratio is considered a more conservative estimate of a firm’s preparedness to meet emergency liability needs.
Also See:
- Difference between Under Subscription and Over Subscription of Shares
- Difference between Convertible and Non-Convertible Debentures
- Difference between Comparative Financial Statement and Common Size Financial Statement
- Difference between Fixed Assets and Current Assets
