Lessons · Accounting · current ratio, quick ratio, debt-to-equity
Three ratios a lender reads first
Current ratio is current assets over current liabilities: can the business pay what is due this year. Quick ratio keeps only what could be cash within about ninety days, so it takes OUT the inventory and it takes out the prepayments too. Debt-to-equity is total liabilities over equity: how much of the business the lenders already own.
Hone is a place to practise a career, one idea a day. This is one of its lessons, written out in full and free to read without an account.
In beta. This lesson was written for Hone and has not yet been checked by a qualified accountant. Practice material, not professional advice. What that means.
What it is for
A lender asks whether the business can pay them back next month, and whether it is already carrying too much debt. These three numbers, straight off the balance sheet, are the first thing they compute.
How to think about it
Take the figures from the balance sheet: current assets, inventory, any prepayments, current liabilities, and total liabilities with equity. Three divisions. Read each as a number, not a percentage.
Worked example
Current assets 30,000 (inventory 12,000, prepaid insurance 2,000); current liabilities 15,000Off the balance sheet. Current means due or usable within a year.
Current ratio = 30,000 / 15,000 = 2.0Two dollars of current assets for every dollar due.
Quick ratio = (30,000 − 12,000 − 2,000) / 15,000 = 1.07Stock out, and the prepaid insurance out with it. A year of cover paid for in advance cannot be handed to a supplier; it comes back as insurance, not as money.
Total liabilities 40,000; equity 50,000 → Debt-to-equity = 40,000 / 50,000 = 0.8Lenders have 80 cents in the business for every dollar of the owner's.
Your turn
Current assets 50,000, of which prepayments 4,000. Current liabilities 20,000, quick ratio 1.3. Write the line with the inventory filled in.
Quick ratio = (50,000 − − 4,000) / 20,000 = 1.3
Solve one, graded on the server
The trap
Taking only the inventory out of the quick ratio and leaving the prepayments in. It is the commoner of the two mistakes because inventory is the one everybody remembers, and it flatters the business every time: rent or insurance paid a year ahead is sitting in current assets, it is genuinely not available to pay anybody, and leaving it in reports a company as more able to pay than it is. The other trap is mixing long-term items into the current ratio -- a building is an asset but it will not pay next month's suppliers; a ten-year loan is a liability but only this year's instalment is current.