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Fundamental analysis is considered to be one of the most reliable methods of investing in public equity, and it has a lot to do with ratios and percentages.
In this article, we’re going to explore two most used ratios in fundamental analysis and understand the major differences between them. We’re also going to learn how to use them both in different scenarios.
What is the current ratio?
Current ratio is the broader and more inclusive of the two. It takes into account all current assets – the readily convertible cash and marketable securities, along with inventory, prepaid expenses, and accrued income.
The current ratio provides a broad view of a company’s ability to handle its short-term debts even if some assets take longer to liquidate. This is particularly relevant for analysing companies with significant inventory or long receivable cycles.
There are also some risks that the current ratio would indicate. For instance, a significant drop in the current ratio may indicate difficulty in meeting upcoming financial obligations, especially if accompanied by other negative indicators like declining revenue or increasing debt.
Making investments with current ratio
Although this ratio is by no means a holistic metric to base your investments on, here is an instance that will help you get your head around the concept:
For long-term investment decisions, a healthy current ratio (typically above 2:1) can provide some reassurance about the company’s ability to manage its working capital efficiently and navigate challenges over time.
However, the typical depends. Compare the ratios to industry averages to understand if the company’s liquidity aligns with its peers.
Understanding the quick ratio
The quick ratio is a more conservative metric compared to the current ratio. This ratio focuses entirely on the most liquid assets, readily convertible to cash within 90 days. Cash equivalents, marketable securities, and accounts receivable expected to be paid within the next quarter are some key numbers in the quick ratio.
The quick ratio highlights the immediate cash cushion available in the company that can be used to meet pressing obligations. This is crucial for industries with volatile cash flows or high reliance on short-term loans.
Similar to the current ratio, a consistently low quick ratio could raise concerns about the company’s ability to handle unexpected short-term shocks or sudden liquidity demands.
Making investments with the quick ratio
Not unlike the current ratio, this metric shouldn’t be the only one you use to base your investments on. However, similar to the current ratio, a fast declining quick ratio might question the company’s ability to meet its short-term obligations, or come up with liquidity to meet an unexpected dip in cash flows.
The differences, visualised
| Feature | Quick Ratio | Current Ratio |
| What it measures | Short-term ability to pay current liabilities | Ability to pay liabilities within a year |
| Assets used | Highly liquid assets: cash, cash equivalents, marketable securities, excluding inventory | All current assets: cash, receivables, inventory, prepaid expenses |
| Calculation | (Cash + Cash Equivalents + Marketable Securities) / Current Liabilities | Current Assets / Current Liabilities |
| Interpretation | More conservative: a lower ratio indicates potential difficulty paying immediate debts | More balanced: provides a broader picture of short-term financial health |
| Use cases | Assessing immediate financial stability, analysing company with large inventories | Evaluating overall liquidity and solvency |
Frequently Asked Questions
Absolutely! Analysing both alongside industry benchmarks and historical data paints a nuanced picture of a company’s liquidity health.
While both offer valuable insights, the current ratio’s broader scope of current assets provides a more relevant lens for longer-term investment decisions.
Not necessarily. High ratios could be artificially inflated by manipulating accounts receivable or delaying payments. Look for consistent trends and industry context before making judgments.
Low ratios may not always spell doom. Analyse the underlying reasons – is it due to seasonal fluctuations, increased investment in inventory, or genuine financial struggles? Investigate further to understand the context.
In the public markets, you can typically find these ratios in their regulatory filings or in their annual reports. If not, you could also check their quarterly filings or their investor presentations.
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