Current ratio vs. quick ratio: Which one is more relevant for your SaaS business
Dec 9 2021
Licensing flexibility, unlimited growth potential, and scalability are some of the upsides of the SaaS business model. A subscription model makes for a predictable revenue stream that allows these businesses to achieve phenomenon growth. Some SaaS firms have achieved unicorn status in five years, growing to the coveted $1B valuations.
To achieve such a meteoric rise, SaaS firms must have a firm grip on their financials. That means going beyond the typical bookkeeping and accounting processes. The use of sophisticated financial ratios such as quick and current ratios offers rarified insights into SaaS financials.
Current ratio and quick ratio are liquidity ratios that measure a company's ability to pay it's short-term debts. The primary difference between the two ratios is the time frame considered and definition of current assets.
The current ratio measures a company's ability to offset its current liabilities or short-term debts with short-term or current assets. It's also known as the working capital ratio.
What is included in the current ratio?
Current ratio calculations only use current assets, assets that can be converted into cash within a year. Likewise, current liabilities are the debts your company owes that are due and payable within a year.
The most common current assets are: account receivables, cash and cash equivalent, securities, inventory, and prepaid expenses. Current liabilities include: accrued liabilities, accounts payable, short-term debts, and other debts.
Current ratio formula
Current ratio calculations use a simple formula:
Current Ratio = Current Assets ÷ Current Liabilities
To calculate the current ratio, add up all of your firm's current assets and divide them with the total current liabilities.
For instance, if your firm's total current assets amount to $250,000 and your total current liabilities amount to $100,000. Your current ratio would be: $250k ÷ $100k = 2.5
That indicates that your firm has $2.5 worth of current assets for every dollar you have in current liabilities.
What is a good current ratio for a company?
Two is the ideal current ratio because you can easily pay off your liabilities without running into liquidity issues. Anything less than two puts your firm in the red zone. It indicates that you have a liquidity problem and don't have enough assets to pay off current debts.
A high current ratio may seem desirable, but anything above four is problematic. It indicates the firm is underutilizing its assets.
What is a quick ratio?
Also called the acid test ratio, a quick ratio is a conservative measure of your firm's liquidity because it uses a fraction of your current assets. Unlike current ratio, quick ratio calculations only use quick assets or short-term investments that can be liquidated to cash in 90 days or less.
What is included in the quick ratio?
You'll include cash and cash equivalent, accounts receivable, and marketable securities in your quick ratio calculations. Typically, you eliminate inventory and prepaid expenses when calculating quick ratios because you can't convert them into cash in 90 days.
However, the current liabilities remain the same and include: short-term debt, accrued liabilities, and accounts payable.
Quick ratio formula
While the quick ratio formula uses current liabilities, it scales down the assets to accommodate the short timeframe, usually about three months.
Quick Ratio = (Cash + Cash Equivalents + Liquid Securities + Receivables) ÷ Current Liabilities
From the example above, a quick recalculation shows your firm now holds $150,000 in current assets while the current liabilities remain at $100,000.
The firm's quick ratio is : 150,000 ÷ 100,000 = 1.5
After removing inventory and prepaid expenses, your business has $1.5 in assets for every dollar in liabilities, which is a great ratio.
What is a good quick ratio for a company?
A quick ratio above one is excellent because it shows an even match between your assets and liabilities. Anything less than one shows that your firm may struggle to meet its financial obligations.
If the quick ratio is too high, the firm isn't using its assets efficiently. While this formula offers insights into virtually any business vertical, it doesn't adequately describe the SaaS model.
Current ratio vs quick ratio: key differences
Both the quick and current ratios are considered liquidity ratios because they measure a firm's short-term liquidity. Since the ratios use the firm's account receivables in their calculation, they're an excellent indicator of financial health and ability to meet its debt obligations.
However, the current ratio and quick ratio have some key differences:
Current ratio calculations include all the firm's current assets, while quick ratio calculations only include quick or liquid assets.
The quick ratio of a company is considered conservative because it offers short-term insights (about three months), while the current ratio offers long-term insights (a year or longer).
Quick ratio only uses quick assets and excludes any assets that can't be liquidated and converted into cash in 90 days or less. The current ratio considers all holdings that can be liquidated and converted into cash within a year.
The quick ratio of a company excludes inventory from its calculations, while current ratio calculations include inventory.
A 2:1 result is ideal for the current ratio, while a 1:1 is the perfect quick ratio for most businesses except SaaS.
Who reviews quick and current ratio
Since these ratios provide insights into a company's liquidity, they're reviewed by different groups of people.
SaaS owners use these formulas to check their firm's liquidity and financial health. They can use them to identify the shortcomings and take quick corrective actions to keep the business in the green.
Creditors use these ratios to determine a firm's credit worthiness. Ideal current and quick ratio numbers attest to its ability to repay loans and settle its debt on time.
Investors use the ratios to determine if a company is a worthy investment. An investor can glean insights into how well a company manages its finances and determine the possible ROI from the ratios.
Calculating SaaS quick ratio to track and reduce customer churn
SaaS companies don't use the same formula to calculate quick ratios because their revenue model doesn't follow the conventional model. Subscription companies view assets and liabilities from a different perspective, and it shows in their financial analysis.
SaaS Quick Ratio = (New MRR + Expansion MRR + Reactivation MRR) ÷ Contraction MRR + Churn MRR)
Let's say for instance, these are the numbers from your SaaS financial statements.
New MRR: $200,000
Reactivation MRR: $150,000
Expansion MRR: $175,000
Churned MRR: $90,000
Your SaaS Quick Ratio = ($250k + $150k +175k) ÷ $90k = 5.8
From the financial analysis, it's clear that your company is growing steadily. You can easily tell that the company has excellent growth MRR and low churn but calculating the SaaS quick ratio puts things into perspective.
A SaaS quick ratio offers profound insights into your company's performance while letting you know which parts need improvement. If your SaaS quick ratio is:
< 1: You may not survive the next two months or less
1 to 4: Your company has a sluggish growth trajectory, and you'll run into cash flow problems if the growth MRR doesn't improve.
4: You have an excellent growth trajectory, and the company is growing efficiently. You're making back four or more times in growth MRR for every dollar you lose or churn.
From the above example, this company's financial health is in the green. It's making back almost $6 for every dollar lost or churned.
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With ProfitWell Metrics, you can monitor and break down your MRR into components such as new MRR, upgrades, existing customers, downgrades, and churn. The unparalleled financial reporting provides a high-level view of your business while letting you dig into specifics.
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Current ratio vs quick ratio FAQs
What is the acid test ratio?
Also known as the quick ratio, the acid test ratio is a conservative liquidity ratio that only uses liquid or quick assets. It excludes inventory and prepaid assets to consider assets that can be turned into cash in 90 days or less.
Why is current ratio important?
The current ratio is important because it helps to assess your firm's liquidity position and financial health. It calculates if the company's current assets are enough to cover its short-term obligations.
How can a company improve its current ratio?
A company can improve its current ratio by using long-term financing, paying off liabilities, lowering its overhead, long-term funding, and optimal receivables and payables management. Bolstering sales also help to improve the liquidity ratio.
How to find current ratio on a balance sheet?
The balance sheet doesn't list the current ratio, but it provides all the information you need to calculate your company's current ratio.
To calculate your firm's current ratio, you need to check all the current liabilities and current assets itemized on the balance sheet. You can then use the current ratio formula (total current assets ÷ total current liabilities) to calculate the current ratio.
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