[Current Ratio][Quick Ratio] Check a company's "short-term solvency"!
When checking a company's financial condition, are you ever concerned about its short-term solvency? Even if a business appears to be doing well, cash flow can become difficult due to sudden payments or unexpected liabilities. To prevent such risks, the "current ratio" and "quick ratio" are important indicators. In this article, we will explain these two indicators in an easy-to-understand manner.
What is the current ratio?
First, let's explain the current ratio. The current ratio is an indicator that shows a company's short-term solvency. Specifically, it shows how much of a company's current assets (assets that can be converted into cash within one year, such as cash and accounts receivable) can cover the liabilities that must be paid within one year (current liabilities).
Current Ratio = Current Assets ÷ Current Liabilities × 100
The higher this ratio, the more cash or liquid assets a company has to cover the liabilities it must pay in the short term. Although it depends on the industry, a current ratio of 150% or higher is generally considered to indicate sufficient solvency.
For example, if the current ratio is 200%, it means the company has twice as many current assets as the liabilities it must pay. Such a company can be said to be secure in its short-term cash flow.
What is the quick ratio?
Next, let's talk about the quick ratio. The quick ratio is a more realistic indicator than the current ratio. The current ratio includes assets in current assets that take time to convert into cash, such as "inventory" and "merchandise." However, to accurately grasp a company's solvency, it is sometimes better to exclude these assets.
Quick Ratio = (Current Assets - Inventory) ÷ Current Liabilities × 100
In this way, the quick ratio considers only assets that can be converted into cash immediately, excluding "inventory" and the like from current assets. This allows for a more practical understanding of solvency. Especially for companies with large inventories, the quick ratio is a more important indicator than the current ratio.
When should these be used?
The best time to check the current ratio and quick ratio is when you want to assess a company's short-term solvency. These indicators are particularly important when cash flow is unstable or when considering new financing. If the current ratio is low, anxiety about short-term payments increases, and the quick ratio allows you to confirm more accurate solvency by excluding inventory. Also, by checking these indicators before signing contracts with business partners or before the fiscal year-end, you can prepare for future management plans and cash flow. They are important indicators, especially for avoiding the risk of a cash shortfall.
What risks are not visible with just the current ratio and quick ratio?
No matter how good the current ratio or quick ratio is, it does not mean you can grasp all risks. For example, if most of the current assets are accounts receivable and the current liabilities are short-term debts that must be paid within one month (accounts payable or unpaid salaries), cash flow can become difficult depending on the timing.
In reality, accounts receivable can take time to collect, and business partners may delay payments. In other words, just because the current ratio or quick ratio is good does not necessarily mean that cash flow is comfortable.
Therefore, it is important to pay attention to the breakdown of current assets and current liabilities. If you do not have a firm grasp of the quality of assets and the timing of payments, you may face a sudden cash shortfall.
Summary
The current ratio and quick ratio are essential indicators for measuring a company's short-term solvency, but they are not sufficient on their own for actual cash flow management. Since various factors such as asset quality, payment timing, and relationships with business partners have an impact, it is necessary to grasp the company's situation comprehensively.
It is important not to rely solely on financial indicators, but to properly manage actual cash flow and minimize risks.
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