How the current ratio works
The current ratio is current assets divided by current liabilities. The quick ratio repeats it with inventory taken out. With $600,000 of current assets, $400,000 of current liabilities and $160,000 of inventory, the two ratios read 1.50 and 1.10. Gross margin on that sheet is 35 percent.
Current ratio
1.50
Take out $160,000 of inventory and the quick ratio is 1.10.
- Quick ratio, inventory removed
- 1.10
- Gross profit
- $700,000
- Gross margin
- 35.00%
Everything due to become cash within a year: cash, receivables, inventory, prepayments.
Everything falling due within a year, including the next twelve months of loan repayments.
Stock on hand. It sits inside current assets, and it is what the quick ratio takes back out.
The top line of the income statement. A full year here, and the same period in the line below.
The cost that only exists because the sale happened, over the same period as revenue. Wages, rent and marketing sit below it.
On this page
In short
- Current ratio is current assets over current liabilities. $600,000 / $400,000 = 1.50. That is a coverage of the next year's bills, not a profit.
- Quick ratio takes inventory out first: ($600,000 - $160,000) / $400,000 = 1.10. Inventory is usually the slowest current asset to turn into cash.
- Gross profit on the same sheet is $2,000,000 of revenue minus $1,300,000 of cost of goods, so $700,000. Gross margin is 35 percent. Liquidity and margin are different claims.
- A software-shaped sheet with $0 inventory and $300,000 of cost of goods on $2,000,000 of revenue keeps the 1.50 current ratio and prints a 1.50 quick ratio and an 85 percent margin. Same current ratio, different firm.
- A 2.00 current ratio with $675,000 of inventory against $450,000 of liabilities can still be a 0.50 quick ratio. Liquid on paper, not once the stock comes out.
Coverage of the next year of bills
The current ratio asks whether the assets that should turn into cash within a year cover the bills that fall due within a year:
On $600,000 of current assets against $400,000 of current liabilities, the ratio is 1.50. The next year of bills is covered on that reading. It is not a profit, and it is not liquidity in the market sense of selling without moving the price. It is a balance sheet coverage.
Take inventory out and you have the quick ratio, sometimes called the acid test. $160,000 of inventory comes out of the $600,000, against the same $400,000, so 1.10. Inventory is usually the slowest current asset to turn into cash, which is why it comes out.
Gross profit is a third line, from a different statement: $2,000,000 of revenue minus $1,300,000 of cost of goods is $700,000, a 35 percent gross margin. The current ratio calculator on this page prints all three so a liquid wholesaler is not confused with a high-margin firm that happens to share a current ratio.
What liquidity means is the wider idea. Working capital is current assets minus current liabilities, the dollar gap behind the ratio.
The same 1.50, a different firm
Keep $600,000 of current assets and $400,000 of current liabilities, so the current ratio stays 1.50. Set inventory to $0 and cost of goods to $300,000 on the same $2,000,000 of revenue. The quick ratio is now also 1.50, because nothing is taken out. Gross profit is $1,700,000. Gross margin is 85 percent.
The coverage of the bills did not change. The mix of what is covering them did, and the margin is a different business. A ratio without the other two lines cannot tell those sheets apart.
Liquid on paper, not once the stock comes out
Current assets $900,000, current liabilities $450,000, inventory $675,000. Current ratio is 2.00, which looks twice-covered. Quick ratio is 0.50, because most of the current assets are inventory against $450,000 of bills. Revenue $5,000,000, cost of goods $3,900,000, gross profit $1,100,000, margin 22 percent.
A 2.00 current ratio that is mostly inventory is a warehouse, not a cash buffer. The quick ratio is the line that says so.
A 2.00 current ratio that is mostly inventory is the case the quick ratio was invented for. Current against quick is the two ratios on one sheet: what each keeps in, what each throws out, and when they disagree.
What this page is not doing
It is not a sector screen, not a cash forecast, and not a claim that 1.50 is healthy. The three sheets are a wholesaler at 1.50 and 1.10 with a 35 percent margin, a no-inventory sheet that keeps 1.50 and prints 85 percent, and a 2.00 current ratio that is a 0.50 quick ratio. This is educational material, not financial advice.
Worked examples
A wholesaler, all three ratios
A distributor holds $600,000 of current assets, of which $160,000 is inventory, against $400,000 of current liabilities. Over the year it sold $2,000,000 of goods that cost $1,300,000 to buy. What do the three ratios read?
- Current ratio is current assets over current liabilities: .
- Take the inventory out to get the quick assets: .
- Quick ratio divides that by the same liabilities: .
- Gross profit is revenue minus the cost of goods sold: $2,000,000 minus $1,300,000 is $700,000.
- Gross margin is gross profit over revenue: , which is 35 percent.
The current ratio is 1.50 and the quick ratio is 1.10, so the next year of bills is covered either way you count. Gross margin is 35 percent, meaning $700,000 of the $2,000,000 in sales is left over to pay wages, rent and everything else that is not the cost of the goods themselves.
Same liquidity, a completely different margin
A software company reports the same $600,000 of current assets and $400,000 of current liabilities, but holds no inventory at all. It bills $2,000,000 a year, and its cost of goods sold, mostly hosting and customer support, is $300,000. How does it compare with the wholesaler?
- The current ratio is identical: .
- Nothing comes out for inventory, so the quick ratio is the same 1.50.
- Gross profit is $2,000,000 minus $300,000, which is $1,700,000.
- Gross margin is , which is 85 percent.
Both liquidity ratios read 1.50, because there is no inventory to strip out. Gross margin is 85 percent against the wholesaler's 35 percent on the same $2,000,000 of sales. Neither company is better run than the other. One buys goods and resells them, the other writes code once and sells it many times, and the margin is mostly telling you which is which.
Liquid on paper, not once the stock comes out
A grocery chain holds $900,000 of current assets against $450,000 of current liabilities, which looks comfortable next to both companies above. But $675,000 of that is stock sitting on the shelves. Revenue is $5,000,000 and the goods cost $3,900,000.
- Current ratio: , the strongest reading on this page.
- Quick assets are what is left once the stock comes out: .
- Quick ratio: , the weakest reading on this page.
- Gross profit is $5,000,000 minus $3,900,000, which is $1,100,000.
- Gross margin is , which is 22 percent.
The same company scores 2.00 on the current ratio and 0.50 on the quick ratio. Three quarters of its current assets are groceries, so the bills falling due in the next year are twice the quick assets standing behind them. For a grocer that sells its stock in days and pays suppliers later, this is ordinary. In a firm holding machine parts that turn over once a year, the identical 0.50 would be a real warning.
Common questions
Is a current ratio above 1 enough?
It means current assets cover current liabilities on the sheet you typed. On the first sheet, 1.50 is $600,000 against $400,000. It does not mean the cash will be in the right place on Tuesday, and it does not mean the inventory will sell at book. The quick ratio of 1.10 is the tighter reading of the same sheet.
Why does inventory come out of the quick ratio?
Because it is usually the slowest current asset to turn into cash. On the first sheet, taking $160,000 of inventory out of $600,000 moves the reading from 1.50 to 1.10. On the third sheet, $675,000 of inventory is most of the current assets, and the quick ratio falls to 0.50.
Is gross margin a liquidity ratio?
No. It is profit on sales before operating costs. The first sheet's 35 percent is $700,000 of gross profit on $2,000,000 of revenue. It can be high while the quick ratio is thin, or low while the bills are covered. That is why this page prints both.
Keep reading
This page is educational material, not financial advice. The figures come from the formula shown and assume the inputs you enter hold for the whole term. Your own rate, fees, taxes and timing will differ, so treat the output as arithmetic to check a decision against, not as a recommendation.