Formula
Current Ratio = Current Assets ÷ Current Liabilities Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities
The Short Version
Liquidity ratios test whether a company can pay its short-term bills using its short-term assets. They're an early-warning system for financial distress.
Explain It Like I'm 10
Imagine you owe $20 in library late fees due this Friday. You check your wallet: you have $10 cash, plus a $15 gift card, plus a video game you could probably sell for $10. Counting everything (even the harder-to-sell game), you technically have enough (current ratio). But if you only count cash and stuff you could turn into money FAST (skipping the game), you might come up a little short (quick ratio) — a stricter, more cautious test.
Step-by-Step Example
- 1 Current assets: $5,000,000. Current liabilities: $2,500,000.
- 2 Current Ratio = $5,000,000 ÷ $2,500,000 = 2.0 — the company has $2 of short-term assets for every $1 it owes soon.
- 3 Of those current assets, $1,000,000 is inventory sitting on shelves (harder to convert to cash quickly).
- 4 Quick Ratio = ($5,000,000 − $1,000,000) ÷ $2,500,000 = 1.6 — still healthy, even under the stricter test.
- 5 If the Current Ratio dropped below 1.0, that would mean the company owes more in the short term than it has readily available — a warning sign worth digging into.
Textbook Example
A company with $5 million in current assets and $2.5 million in current liabilities has a current ratio of 2.0.
Quick Recap
- ✓ A current ratio below 1.0 means current liabilities exceed current assets — a potential red flag.
- ✓ The quick ratio ('acid-test ratio') is stricter, excluding inventory since it isn't always quickly convertible to cash.