The Current Ratio is one of the most commonly used ratios to measure a company’s short-term financial strength. It is arrived at by following the formula shown below:

Current Ratio = Total Current Assets / Total Current Liabilities

Current assets are the assets that are expected to be converted into cash in the next operating cycle. The cash from current assets is used to pay off current liabilities, which are scheduled for payment during the next operating cycle. A company should have enough current assets to meet its current liabilities. The higher a company's current ratio, the higher their margin of safety is since there is a possibility to lose some current assets, such as inventory write-offs or bad debts.   If a company has a low current ratio (less than 1x) it indicates a potential short term liquidity crunch, and a possibility that they will not be able to meet their short term obligations.

While a generally acceptable current ratio is 2x (.i.e. current assets should be twice the current liabilities), a satisfactory ratio is relative to the nature of the business.  Moreover, while judging the current ratio, it is important for an analyst to look at the composition of current assets and liabilities. A company may have a very high current ratio of 3x, but if most of the current assets are locked in the form of inventory, a high current ratio may not indicate a good liquidity position. In this case, it is crucial to know the characteristics of the inventory. If the inventory consists of old product that is not selling well, the company may have to write off the inventory and the current ratio may drop significantly. However, if a large portion of their inventory consists of new products that the company is expecting to sell during the next business cycle, a high current ratio is a sign of healthy short term liquidity position. Similarly, a high current ratio may also indicate a large amount of idle cash being accumulated and not reinvested into the business.

Quick Ratio

The quick ratio is also referred to as the ‘Acid-Text ratio’. It is considered to be one of the best ratios for judging a company's ability to pay off its short term debts and is a more difficult test for a company to pass. As mentioned above, inventories are subject to writeoffs, in certain cases and are therefore considered to be the least liquid component of current assets. While this ratio is similar to current ratio, it excludes inventories from current assets.

Quick Ratio = (Total Current assets – Inventories) / Total Current Liabilities

By excluding inventories, the quick ratio concentrates on the most liquid assets (including cash, government securities and receivables). A higher quick ratio indicates that even if sales revenue were to disappear, the company would still be in a position to meet its current obligations with readily available current assets. A quick ratio of 1x is considered acceptable, unless the majority of the quick assets are in the form of accounts receivable. In this case, the pattern of accounts receivable collection needs to be studied to find if the average collection period lags behind the schedule for paying current liabilities.

Interest Coverage Ratio

The interest coverage ratio is also called the ‘times interest earned ratio’ and measures the margin of safety available to a company before paying the interest liabilities on their debts. In other words, it indicates the amount of profit a company makes before paying interest. It is used by investors and creditors to judge the financial risk position of a company. It is calculated as follows:

Interest Coverage ratio = Profit before interest and taxes/ interest

Interest is a tax-deductible expense. The ability of a company to pay interest is not affected by tax payments. Hence the numerator used in the ratio is profit before interest and taxes. A high interest coverage ratio is an indication that the company can easily meet its interest payments even if its profit before tax suffers a considerable decline.  A company having a low coverage ratio is perceived to be financially risky since a minor decline in operating profit can result in an inability to meet their interest payments.  It is also used by lenders to measure the debt capacity of a company.