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In this lesson I'll discuss two very useful ratios, the current ratio and the quick ratio, also known as the acid test. If you want to evaluate a company's short -term financial health, one of the best ratios you can use is the current ratio, which compares a company's current assets to its current liabilities. A current asset is an asset that can be reasonably assumed to be converted to cash within one year. Current assets include cash, accounts receivable, and inventory. Similarly, a current liability is a liability that must be paid within one year.
To find a company's current ratio, you divide the value of current assets by the value of current liabilities. I have those values here in this worksheet. It's just data from a fictitious company, current assets and current liabilities. To calculate the current ratio, create a formula that divides current assets by current liabilities, and there is the result. Most healthy companies have a current ratio of at least 1 indicating that their assets are greater than their liabilities. You can also use the two values from the current ratio, current assets and current liabilities, to determine the company's working capital.
To calculate working capital, which is essentially the cash the company has on hand, you subtract current liabilities from current assets. So in this case we have B5, Current Assets, - B6, Current Liabilities, and there is the amount of working capital that you have. The higher the current ratio, the better. But a low current ratio most likely won't be a problem for a company that has the potential to borrow money to increase its cash on hand. Unless a company makes its money exclusively through consulting services or licensing its patents and other intellectual property, it will make its money by selling physical goods.
Goods in inventory must be sold to be converted to cash, so analysts developed the quick ratio. The philosophy behind the quick ratio is that because inventory is the least liquid asset, you should exclude it from the current assets calculation by subtracting the value of goods and inventory and then divide the new total by current liabilities. Here we have current assets and inventory is called out separately and we have current liabilities. So the quick ratio would be B5-B6 and divide that by B8 to get the quick ratio.
Now be aware that companies can alter their quick ratio by choosing when to make major purchases or sell off assets. If a company intends to buy patents or other intellectual property from another firm, you should take that into account if it looks like the deal has been reached before the end of a fiscal year. It's vital that you only use the quick ratio to compare companies with similar business models. A consulting firm, for example, would carry no inventory. So its quick ratio would be the same or very nearly the same as its current ratio. A department store chain, by contrast, would have a large inventory and therefore a much lower quick ratio than the consulting firm.
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