Current Ratio and Liquid Ratio: Meaning, Formula, and Comparison Table
Understanding the difference between current ratio and liquid ratio is crucial for students of commerce and anyone interested in business analysis. These two accounting ratios help assess a company's short-term liquidity, which is a common theme in school exams, competitive exams, and practical business evaluations. By mastering these concepts, students gain clarity and confidence in financial ratio analysis for real-world and academic applications.
| Aspect | Current Ratio | Liquid Ratio (Quick Ratio) |
|---|---|---|
| Definition | Measures all current assets versus current liabilities. | Measures only liquid (quick) assets versus current liabilities. |
| Formula | Current Ratio = Current Assets / Current Liabilities | Liquid Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities |
| Assets Included | All current assets (cash, receivables, inventory, prepaid expenses, etc.) | Cash, marketable securities, and accounts receivable (excludes inventory and prepaid expenses) |
| Liquidity Strength | Less strict; may overstate liquidity if inventory is hard to convert to cash. | More strict; focuses only on assets quickly converted to cash. |
| Ideal Value | 2:1 | 1:1 |
Current Ratio
The current ratio is a primary liquidity ratio in accounting. It compares a company's current assets to its current liabilities. Current assets are items such as cash, bank balances, inventory, and trade receivables that can be converted into cash within one year. Current liabilities are debts or obligations due within one year, like accounts payable or short-term loans.
Formula of Current Ratio
Current Ratio = Current Assets / Current Liabilities
Components of Current Assets and Liabilities
- Current Assets: Cash, bank balance, trade receivables, inventory, prepaid expenses, short-term investments.
- Current Liabilities: Creditors, bank overdraft, outstanding expenses, short-term borrowings, taxes payable.
An ideal current ratio is usually 2:1. This means a company has twice the current assets compared to its current liabilities, showing enough resources to meet its short-term obligations. More information on these concepts can be found at Current Assets and Current Liabilities.
Liquid Ratio (Quick Ratio)
The liquid ratio, also called the quick or acid-test ratio, is a more stringent measure of a firm’s liquidity. It excludes inventory and prepaid expenses from current assets, focusing only on assets that can quickly become cash, usually within 90 days.
Formula of Liquid Ratio (Quick Ratio)
Liquid Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
Liquid Assets Meaning
- Cash in hand and at bank
- Marketable securities
- Trade receivables (debtors, bills receivable)
Prepaid expenses and inventory are not included because they may not be quickly converted into cash. The ideal liquid ratio is 1:1, indicating the company has enough liquid assets to meet its immediate liabilities. For detailed understanding, visit Liquid Assets.
Practical Example: Calculation of Ratios
Let’s see how these ratios work with an example. Suppose a company’s balance sheet shows:
- Cash: ₹50,000
- Bills Receivable: ₹20,000
- Inventory: ₹40,000
- Prepaid Expenses: ₹5,000
- Trade Payables: ₹45,000
- Bank Overdraft: ₹5,000
Current Assets = Cash + Bills Receivable + Inventory + Prepaid Expenses = ₹50,000 + ₹20,000 + ₹40,000 + ₹5,000 = ₹1,15,000
Current Liabilities = Trade Payables + Bank Overdraft = ₹45,000 + ₹5,000 = ₹50,000
Current Ratio = ₹1,15,000 / ₹50,000 = 2.3:1
Liquid Assets = Current Assets – Inventory – Prepaid Expenses = ₹1,15,000 – ₹40,000 – ₹5,000 = ₹70,000
Liquid Ratio = ₹70,000 / ₹50,000 = 1.4:1
This means the company is in a healthy short-term financial position according to both ratios. You can practice more problems at Ratio Analysis and Accounting Ratios on Vedantu.
Significance and Use in Business
Both the current ratio and liquid ratio are important for assessing a company’s ability to pay its short-term debts. Managers, investors, and creditors use these ratios before making lending or investment decisions. Businesses with good ratios usually attract more trust and credit from banks. Detailed uses and implications are discussed in Final Accounts and Working Capital.
- Current ratio is useful for general liquidity analysis.
- Liquid ratio gives a clear picture of the immediate liquidity position.
- Different industries may prefer one ratio over another based on inventory turnover speed and business model.
Difference Between Current Ratio and Liquid Ratio
The main difference between current ratio and liquid ratio is that the current ratio considers all current assets, while the liquid ratio excludes inventory and prepaid expenses. This makes the liquid ratio a stricter and more reliable indicator of a company’s short-term liquidity. Here’s a quick comparison:
| Point of Difference | Current Ratio | Liquid Ratio |
|---|---|---|
| Definition | All current assets vs. current liabilities | Liquid (quick) assets vs. current liabilities |
| Formula | Current Assets / Current Liabilities | (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities |
| Assets Included | Cash, inventory, receivables, prepaid expenses, etc. | Cash, receivables, marketable securities (no inventory or prepaid expenses) |
| Ideal Ratio | 2:1 | 1:1 |
| Strictness of Test | Less strict, may overstate liquidity | More strict, reliable for immediate payments |
Summary
In summary, both the current ratio and liquid ratio are key liquidity ratios in accounting. The current ratio includes all current assets, while the liquid (quick) ratio only considers easily convertible assets. Understanding their differences helps students and business professionals judge a company’s short-term solvency. For challenging problems and deeper study, Vedantu provides detailed resources and explanations on these essential commerce topics.
FAQs on Difference Between Current Ratio and Liquid Ratio Explained
1. What is the main difference between current ratio and liquid ratio?
The current ratio and liquid ratio (also known as the quick ratio) are both liquidity ratios used to assess a company's short-term financial health. The main difference lies in the assets included: the current ratio considers all current assets, while the liquid ratio excludes inventories and prepaid expenses, providing a more conservative view of immediate debt-paying ability.
2. Are liquid ratio and quick ratio the same?
Yes, liquid ratio and quick ratio are essentially the same. Both measure a company's ability to meet its short-term obligations using its most liquid assets. They exclude less liquid assets like inventories to give a more stringent assessment of immediate solvency.
3. What items are included in current assets but not in liquid assets?
Current assets included in the current ratio but excluded from the liquid ratio (quick ratio) are primarily inventories and prepaid expenses. These assets are less liquid and may not be easily convertible to cash to meet immediate liabilities.
4. What are the formulas for current ratio and liquid ratio?
The formulas are:
Current Ratio = Current Assets / Current Liabilities
Liquid Ratio (Quick Ratio) = (Current Assets - Inventories - Prepaid Expenses) / Current Liabilities
5. Which ratio is more suitable for assessing a company’s immediate solvency?
The liquid ratio (quick ratio) is generally considered more suitable for assessing immediate solvency because it focuses only on the most liquid assets readily available to meet short-term debts. The current ratio, while useful, includes less liquid assets like inventories, which might not be easily converted to cash.
6. What is the difference between current and liquid assets?
Current assets are assets expected to be converted into cash within one year. Liquid assets are a subset of current assets; they are easily and quickly convertible into cash with minimal loss of value. Examples include cash, marketable securities, and accounts receivable, excluding inventories.
7. Is a liquidity ratio a current ratio?
No, a liquidity ratio is a broader term encompassing various ratios that assess a company's ability to meet its short-term financial obligations. The current ratio is one type of liquidity ratio, but others exist, such as the quick ratio (or liquid ratio) and cash ratio.
8. What is the difference between current and quick liquidity ratio?
The current ratio uses all current assets in its calculation, while the quick ratio (or quick liquidity ratio) is more conservative, excluding inventories and prepaid expenses. The quick ratio provides a stricter measure of a company's ability to pay off its short-term liabilities immediately.
9. What is the difference between current ratio and liquid ratio class 12th?
The difference between the current ratio and the liquid ratio (quick ratio) remains the same at the Class 12 level. The current ratio includes all current assets, while the liquid ratio excludes inventories, offering a more stringent measure of short-term solvency. Understanding this difference is crucial for Class 12 commerce exams.
10. Difference between profitability ratio and liquidity ratio?
Profitability ratios measure a company's ability to generate profits, while liquidity ratios assess its ability to meet its short-term financial obligations. They focus on different aspects of financial health: profitability on earnings and liquidity on cash flow and short-term debt.
11. How to calculate current ratio?
The current ratio is calculated by dividing current assets by current liabilities: Current Ratio = Current Assets / Current Liabilities. This ratio indicates the firm's ability to pay off its short-term debts using its current assets.
12. How to calculate liquid/quick ratio?
The liquid ratio (or quick ratio) is calculated as: Liquid Ratio = (Current Assets - Inventories - Prepaid Expenses) / Current Liabilities. It provides a more stringent measure of short-term liquidity by excluding less liquid assets.
