Are the CIPS exam questions on current ratio and quick ratio difficult to answer?
Most students are afraid of exam questions involving financial caculation as they struggle to remember the formulas. Many students cram for the exam, which does not allow them sufficient time to absord financial concepts coverd in the CIPS books. You can only keep this content in your head if you understand them deeply and practice regularly. There is variety of financial ratios which provide you with different insights. Selecting appropriate ones will depend on your purposes. In this post, I will share insights about current ratio and quick ratio, helping you prepare more effectively for the CIPS exam.
Now let’s look at two phrases: current ratio and quick ratio, then break them down into individual words.
- Ratio: This is a way to compare two quantities to show how many times one number contains another (for example: 2:1; 5:3…). We have to use division to calculate the ratio.
- Current: It refers to something which is happening in the present moment.
- Quick: It refers to something that happens rapidly.
After analyzing the individual words, we begin examining the formulas for these ratios and exploring why they are named that way.
Current ratio:
Current ratio = Current Assets / Current Liabilities
Current assests refer to a company’s total of assets which can be converted into cash or used up within one year or within its operating cycle. The “current” word carries a metaphorical meaning, implying the short-term nature and high liquidity of these assets. Which type of assets are categorized as current assets? They can be:
- Cash & equivalents: Physical cash or bank balance
- Accounts receivable: Money owned by customers who purchased goods/services
- Inventory: Raw materials, components and finished products which can be sold to get money back
- Prepaid expenses: It refers to the payment made in advance, which help the company operate smoothly and generate profit.
- Marketable securities: It refers to the short-term investment which can be easily sold for cash.
Current liabilities refers financial obligations that are due within a short-time frame, typically within one year or within the compnay’s operating cycle. Again, the word “current” highlights the short-term nature of these obligations, normally one year or slightly longer if the company has a long operating cycle. What types of financial obligations must a company fulfill in a short time? They can be:
- Accounts payable: It refers to payments to suppliers or other parties
- Short-term debt: It refers to short-term loans of the company
- Accrued expenses: It refers to the expenses incured by the company and these expense are not yet paid.
- Taxes payable: It refers to the income or sale taxes which are owed to the governement. The company is often required to fulfil the tax obligation monthly, quaterly and annually.
- Dividents payable: It refers to the money owed to the shareholders.
- Defered revenues: It refers to the customer’s payment in advance, but the company has not delivered the goods or services that are equivalent to that payment.
Why is the current ratio calculated by dividing current assets by current liabilities? Acting as a buyer, you may want to know how many time a supplier’s current assets exceed their current liabilities. If the ratio is greater than 1, the supplier is able to fulfill their short-term obligations and they can manage to deliver orders in a timely manner. When encountering unexpected events, the company can quickly liquidiate their current assets to meet its financial commitments.
Quick ratio:
The quick ratio = Quick assets / Current Liabilities
Many students often mistake current ratio for quick ratio because these formulas are quite similar. However, the key difference lies in the numerators of the formulas: current assets and quick assets. The word “quick” refers to assets which can be rapidly converted into cash to fulfill the financial obligations. It is important to keep in mind that the quick ratio excludes inventories and prepaid expenses from the current assets as these items are not easily converted into cash.
The company may take several weeks or even months to sell their inventories and the value may fluctuate due to declining demand. Besides, the compay may struggle to convert the prepaid expenses into cashs. For example, if the company pays office leasing fees to the lessor for an entire year, it may be unable to cancel the leaning contract and get a full refund. Transfering the lease to another party could also be time-consuming.
In the CIPS exam, you are required to define the formulas of these ratios and explain their implications. Clearly, the exam questions are not challenging. You can easily walk through them if you spend enough time exploring the significance of these ratios.
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