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Both the current and quick ratios use information off of the balance sheet to measure the liquidity of a firm. With these ratios, we're attempting to gauge whether or not the firm could cover its short-term obligations if the firm were to experience cash flow problems.

In short, the current and quick ratios help us evaluate whether or not a firm has enough current assets, meaning assets that are cash or can be converted to cash within a year, to meet its short-term debt obligations. These short-term debt obligations are known as current liabilities, and they include any liabilities that will become due within one year.

Common current assets include cash, cash equivalents, accounts receivable, inventories, as well as other short-term investments. Common current liabilities include things like accounts payable, wages payable, interest payable, as well as other short-term debt obligations.

Now that we've discussed the basic elements of both ratios lets walk through how to actually calculate them. Lets start with the current ratio. To calculate the current ratio you first need to determine the amount of a firms current assets and current liabilities. These are commonly reported in total on a firms balance sheet as separate entries. Once you've located both current assets and current liabilities, divide the firm's current assets by its current liabilities.

Although a current ratio of 2.0 is considered adequate for most industries you'll want to look at what is common for the industry. A current ratio of 2.0 may be great for some industries, but it may be dangerously low for others.

The quick ratio is almost identical to the current ratio, however it attempts to solve one dangerous assumption that the current ratio makes. Is it reasonable for a firm to assume that it will be able to convert all of its inventory into cash within the next year? Unfortunately it isn't. The truth is that inventory becomes obsolete quickly, especially for technology goods. Inventory also becomes damaged, stolen, and often just sits on store shelves. This assumption can be particularly harmful for a retailer, which often carries a large percentage of its current assets in inventory due to the very nature of its business.

In order to take a more conservative approach to gauging the liquidity of a firm we use the quick ratio. In order to calculate the quick ratio we still gather the current assets and the current liabilities of a firm, but prior to our calculations we deduct inventories from current assets. That way we're not assuming a firms inventory will be there to assist in covering their current liabilities. Now truthfully some inventory, maybe even a large percentage of it, will be sold. However, just in case it doesn't we're prepared.

Generally a quick ratio of 1.0 is adequate, so you could say that we have some liquidity issues given our current financial position. Once again though, researching the industry average will help us get a more accurate gauge on what is an acceptable quick ratio.

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