Liquidity Ratios: Current, Quick and Cash Compared

Three ratios ask how much of what falls due inside twelve months a business could meet, and they differ only in what each is willing to count as available. The current ratio counts every current asset, the quick ratio drops inventory, and the cash ratio counts cash alone. Anjani Stationers returns 4.25, 3.25 and 0.18 times, and that spread is the most informative thing the set produces.

The instrument opens on the year two figures in full. On the asset side, inventories of Rs 28,00,000, trade receivables net of the provision of Rs 86,00,000 and cash of Rs 5,00,000 add to Rs 1,19,00,000. On the liability side, trade payables of Rs 22,00,000 owed to the paper mills, the Rs 4,00,000 the schools have already paid for notebooks not yet made, and the Rs 2,00,000 of lease payments falling due inside the year add to Rs 28,00,000. Divided three ways those give 4.25 times, 3.25 times and 0.18 times, and every figure the instrument prints before any input changes is one of those nine.

All three are the same fraction with the same denominator. Something the business holds is divided by everything it must settle inside the year, and the only decision anyone is making is which assets go into the top line. The choice of numerator produces the whole spread. No accounting standard prescribes any of the three, and no filing performs the division. Every input is a figure already printed on the face of the balance sheet or in a note beside it.

What does each of the three ratios actually count?

Start with the picture rather than the formula. Anjani Stationers Private Limited, an invented business making school notebooks and exercise books, reports Rs 1,19,00,000 of current assets at 31 March of year two, split as trade receivables of Rs 86,00,000 net, inventory of Rs 28,00,000 and cash of Rs 5,00,000. Against that sits Rs 28,00,000 of current liabilities.

The three ratios are one calculation run three times on a shrinking numerator, and every difference between them is a decision about what is allowed into the top line. Watch the same Rs 1,19,00,000 get smaller as each measure refuses one more thing. The denominator never changes. Only the permission changes.

How is the current ratio built, and what is it assuming?

Rs 1,19,00,000 divided by Rs 28,00,000 gives 4.25 times. The division is the entire calculation, and it takes eleven seconds. The assumption underneath it takes longer to state than the arithmetic does: the current ratio treats everything the business classed as current as though it will become cash inside twelve months, at the amount printed. The ratio does not test that classification. The classification is inherited whole.

Think of a household counting what it could raise before the next school fee falls due. The bank balance counts. The salary already earned but not yet credited counts. The cupboard full of unsold sarees from a shop counts too, at the price marked on them, and the arithmetic will not ask whether anybody wants sarees this month. The current ratio makes exactly that count and stops there.

Why does the quick ratio drop inventory and nothing else?

Take inventory out and the numerator falls to Rs 91,00,000. The ratio then reads Rs 91,00,000 over Rs 28,00,000, or 3.25 times exactly. The reason for the exclusion is not that inventory is a lesser asset. Inventory is excluded because it has to be sold before it becomes cash, and selling it is precisely the thing a business under pressure cannot do quickly at the price on the label.

Every other current asset is already one step from cash. A receivable needs a customer to pay an amount both sides have agreed. Inventory needs a buyer to be found, a price to be agreed, an invoice to be raised, and then a collection period on top of all of that. Inventory carries two conversions where the others carry one, and the second conversion is the one that fails first when a business needs money urgently. Rs 28,00,000 of exercise books in a warehouse in April is a different object from Rs 28,00,000 of exercise books in a warehouse the week a printing bill falls due.

What is left when only cash counts?

Anjani Stationers holds Rs 5,00,000 of cash and cash equivalentsMoney in hand and in the bank, plus short term holdings so close to cash that they can be turned into a known amount at almost no notice and with almost no risk of the amount changing. against Rs 28,00,000 of current liabilities, so the cash ratio is 0.18 times. Read the same fraction as a share and it says the bank balance on 31 March would settle 17.86 per cent of what falls due inside the year.

Of the three measures, only the cash ratio makes no assumption whatsoever about conversion, and that is exactly why it returns a number so much smaller than its two neighbours. Nothing has to be sold, collected, chased or agreed. The money is there or it is not. A business that pushed this ratio to 1.00 would need Rs 28,00,000 sitting in a bank account on the reporting date, doing nothing between then and the day each bill is actually presented. Holding that much idle cash is a real choice with a real consequence for what the money could otherwise have been doing, and the ratio itself reports neither side of it.

The payment can also run the other way. Settling Rs 5,00,000 of the trade payables with the whole of that cash on 31 March takes both halves of every fraction down by the same amount, current assets to Rs 1,14,00,000 and current liabilities to Rs 23,00,000. Taking an equal amount off the top and the bottom of a fraction already above one pushes it up, so the current ratio then reads 4.96, higher than it was, on a payment that left the business holding no cash at all. The cash ratio on that same payment reads zero, and the quick ratio reads 3.74. The slider in the calculator above makes that payment, in steps of twenty five thousand rupees, so the three readings can be watched separating as the money leaves.

Why does one business read 4.25 and 0.18 at the same time?

Put the three readings on one scale and the temptation is to decide which one is telling the truth. None of them is lying and none of them disagrees with the others. Each ratio is answering a stricter version of the same question, so reading the three in sequence shows what the comfort in the first number is actually made of.

Here it is made of receivables. Divide each component by the same Rs 28,00,000 and the 4.25 breaks into three contributors: receivables supply 3.07, inventory supplies exactly 1.00, and cash supplies 0.18. Each contributor is the same division performed on one part of one total, so the three add back to 4.25 precisely. Roughly seventy two per cent of the headline reading is money that sixty-odd schools have agreed to pay and have not yet paid.

What do these ratios count but never grade?

Look again at the Rs 86,00,000 doing seventy two per cent of the work in that 4.25. Behind it sits a gross invoiced balance of Rs 95,00,000, a provision for doubtful debtsAn amount deducted from the invoiced balance for the part the business does not expect to collect. The balance sheet shows the figure after this deduction. of Rs 9,00,000, and a collection period of 128.4 days measured on the gross balance against revenue of Rs 2,70,00,000. The stated credit terms are thirty days.

These three measures count assets and never grade them, so the current ratio treats a rupee outstanding for four months exactly as it treats a rupee sitting in the bank. The blindness is not a defect to be fixed by choosing a different ratio. Counting without grading is what a ratio is. A fraction has room for one number in the numerator and it cannot also carry an age, a customer name or a history of late payment.

Age, expected loss and concentration are all published beside the balance sheet. The ageingA schedule that splits a receivables balance by how long each amount has been outstanding, usually in bands such as under six months, six months to one year, and beyond. schedule in the receivables note splits the balance by how long it has been owed. The provision note shows what the business itself expects not to collect and how that expectation moved. The concentration disclosure shows how much of the book belongs to one customer group. For Anjani Stationers, one school group accounts for about forty per cent of the balance and collects at roughly 171 days against 110 days for everyone else. None of those three facts can enter a liquidity ratio, and all three are printed nearby in the same set of accounts.

Can two balance sheets read the same and hold nothing alike?

Hold the totals still and move the money around inside them. The split appears nowhere in the fraction, so current assets of Rs 1,19,00,000 and current liabilities of Rs 28,00,000 give a current ratio of 4.25 times regardless of how those current assets are split. Two balance sheets can report an identical current ratio while one holds Rs 5,00,000 of cash and the other holds Rs 63,00,000, and the headline measure records no difference whatsoever between them.

The compositionHow a total is divided among the individual lines that make it up. Two totals can be equal while their compositions are entirely different. shows up the moment a stricter measure is applied. On the published split the quick ratio reads 3.25 and the cash ratio 0.18. On a split holding Rs 63,00,000 of cash, Rs 42,00,000 of receivables and Rs 14,00,000 of inventory, the same total gives a quick ratio of 3.75 and a cash ratio of 2.25. The second and third measures separate the two sheets by a wide margin. The first cannot separate them at all.

What do all three miss entirely?

Three things sit outside every one of these fractions, and each of them is real money.

The first is an undrawn facilityCredit a lender has already agreed to make available that the business has not yet taken. It can usually be drawn on short notice, and it appears in the borrowings note rather than on the face of the balance sheet.. A sanctioned limit the business has not yet touched is liquidity a lender has already committed, and because nothing has been drawn there is no asset and no liability to record. An undrawn limit appears in none of the three numerators and none of the three denominators. A business with a large undrawn limit and a low cash ratio is not describable by any of these measures.

The second runs the other way. A borrowing dated to fall due after the reporting date is classified as non-current and drops out of the denominator entirely, even where it must be renegotiated with a lender who is under no obligation to renew it. The fraction reads the date, not the negotiation.

The third is that all three ratios are measured on one day of three hundred and sixty five, and the day chosen is the one the business itself set as its year end. Anjani Stationers is exactly this case. Borrowings on 31 March stood at Rs 10,20,000, against an average of about Rs 37,00,000 across the year. A cash credit facilityA running borrowing limit against which a business can draw and repay repeatedly through the year, commonly used to fund a seasonal build up of stock and receivables. was drawn through the school buying season and cleared before the year end. The seasonal borrowing was real, it was used, and it is invisible in every ratio computed on the reporting date.

How did the same three ratios read a year earlier?

Run the identical arithmetic on year one and the readings fall across the board. Every input below is a figure already published for this business, and the year one split of liabilities between current and non-current is the assumed split carried through from the balance sheet work, labelled as assumed wherever the resulting figure appears.

All three ratios fell, and not one rupee of the fall came from the numerator, because current assets rose 17.8 per cent while current liabilities rose 86.7 per cent. Hold the denominator at the year one figure of Rs 15,00,000 and year two current assets of Rs 1,19,00,000 would have produced 7.93 times. The entire movement is the bottom of the fraction. The direction does not depend on the assumed split either: take the whole of year one liabilities of Rs 21,00,000 as current and the ratio still reads 4.81 and still falls.

Now put that beside the other diagnostic already published for the same two years. The working capital cycle lengthened from 129.6 days to 143.1 days, and receivables grew from Rs 75,00,000 to Rs 86,00,000 with the collection period stretching from 118.6 days to 128.4. So the current ratio fell in a year when the slowest asset in the numerator grew. The same movement can be produced by the numerator, by the denominator, or by both pulling against each other, so a liquidity ratio moving in one direction is never by itself evidence about what happened inside the business.

Where does each input sit in a filing?

Every figure these three ratios need sits in two places in a filed set of accounts, and a reader who knows the locations can build all three in about two minutes.

The six field notes

Total current assets is the subtotal on the face of the balance sheet, under the current heading, and the classification behind it is the business's own. Inventories is a separate line inside that subtotal, with the split by class in the inventory note. Trade receivables is a separate line shown net, with the gross balance, the provision and the ageing bands set out in the receivables note. Cash and cash equivalents is a separate line, and it must agree with the closing balance of the cash flow statement. The agreement is the quickest check available on the figure. Total current liabilities is the subtotal on the face, on the equity and liabilities side. Sanctioned limits and undrawn amounts, where they are disclosed at all, sit in the borrowings note and never on the face of the sheet.

How does a lender actually assemble these three?

A credit officer preparing a working capital limit for a business like Anjani Stationers does not compute one ratio and stop. The documents get opened in a fixed order, and the sequence is mechanical enough to be worth knowing.

The three ratios are the first three lines of a credit sheet, not its conclusion, and each line is followed by a document request rather than a judgement. The current ratio is computed first, from the two subtotals printed on the face of the balance sheet. The quick ratio is computed next, and the difference between the two is read straight off the inventory line. The inventory line sends the officer to the inventory note for the split between raw material and finished goods. The cash ratio is computed third, and it is reconciled against the cash flow statement's closing balance. Then the officer opens the receivables note for the ageing and the concentration, opens the borrowings note for sanctioned limits, drawn amounts and undrawn balances, and asks the business for the monthly drawing history against the cash credit account. Only that history shows the position on days other than 31 March.

A household does the same thing without the paperwork. Before agreeing to a large expense, a person counts the bank balance, then the salary already earned and due next week, then the deposit better left unbroken, and then checks whether the overdraft on the account is still available. Four different answers to one question, each one stricter than the last, and the useful thing is the sequence rather than any single figure in it.

Anjani Stationers Private Limited, Chitra Binding Works, the Sunrise Public School group and Vaidehi Rao are invented.
Educational material. Not advice on any investment, tax, budget or market position.