In order to survive, firms must be able to meet their short-term obligations—pay their creditors and repay their short-term debts. Thus, the liquidity of the firm is one measure of a firm’s financial health. Two measures of liquidity are in common:
Current ratio = current assets / current liabilities
Quick ratio = (cash + marketable securities + net receivables) / current liabilities
The main difference between the current ratio and the quick ratio is that the latter does not include inventories, while the former does.
Which ratio is a better measure of a firm’s short-term position? In some ways, the quick ratio is a more conservative standard. If the quick ratio is greater than one, there would seem to be no danger that the firm would not be able to meet its current obligations. If the quick ratio is less than one, but the current ratio is considerably above one, the status of the firm is more complex. In this case, the valuation of inventories and the inventory turnover are obviously critical.
A number of problems with inventory valuation can contaminate the current ratio. An obvious accounting problem occurs because organizations value inventories using either of two methods, last in, first out (LIFO) or first in, first out (FIFO). Under the LIFO method, inventories are valued at their old costs. If the organization has a substantial quantity of inventory, some of it may be carried at relatively low cost, assuming some inflation in overall prices. On the other hand, if there has been technical progress in a market and prices have been falling, the LIFO method will lead to an overvalued inventory. Under the FIFO method of inventory valuation, inventories are valued at close to their current replacement cost. Clearly, if we have firms that differ in their accounting methods, and hold substantial inventories, comparisons of current ratios will not be very helpful in measuring their relative strength, unless accounting differences are adjusted for in the computations.
A second problem with including inventories in the current ratio derives from the difference between the inventory’s accounting value, however calculated, and its economic value. A simple example is a firm subject to business-cycle fluctuations. For a firm of this sort, inventories will typically build during a downturn. The posted market price for the inventoried product will often not fall very much during this period; nevertheless, the firm finds it cannot sell very much of its inventoried product at the so-called market price. The growing inventory is carried at the posted price, but there really is no way that the firm could liquidate that inventory in order to meet current obligations. Thus, including inventories in current assets will tend to understate the precarious financial position of firms suffering inventory buildup during downturns.
Might we then conclude that the quick ratio is always to be preferred? Probably not. If we ignore inventories, firms with readily marketable inventories, appropriately valued, will be undeservedly penalized. Clearly, some judicious further investigation of the marketability of the inventories would be helpful.
Low values for the current or quick ratios suggest that a firm may have difficulty meeting current obligations. Low values, however, are not always fatal. If an organization has good long-term prospects, it may be able to enter the capital market and borrow against those prospects to meet current obligations. The nature of the business itself might also allow it to operate with a current ratio less than one. For example, in an operation like McDonald’s, inventory turns over much more rapidly than the accounts payable become due. This timing difference can also allow a firm to operate with a low current ratio. Finally, to the extent that the current and quick ratios are helpful indexes of a firm’s financial health, they act strictly as signals of trouble at extreme rates. Some liquidity is useful for an organization, but a very high current ratio might suggest that the firm is sitting around with a lot of cash because it lacks the managerial acumen to put those resources to work. Very low liquidity, on the other hand, is also problematic.