Current Ratio

Accounting and finance professionals use the current ratio to gauge a company’s financial health at any given moment. The current ratio measures a firm’s ability to pay its short-term liabilities with its current assets. It also indicates the available liquidity the company has for operational needs.

What is the Current Ratio?

The current ratio—also referred to as the working capital ratio—is a numerical measure of liquidity. It compares an organization’s current assets (i.e., those easily converted to liquid cash) to its current liabilities (i.e., debt obligations due within the next twelve months).

For financial operations teams, the current ratio is a helpful measure of liquidity, risk, and financial strength.

Accounting teams also use this ratio since they deal closely with reporting assets and liabilities on the balance sheet.

Investors and creditors use the current ratio to assess the financial health of a business before lending it money or investing in it.

A high current ratio indicates that the firm is in an investment-worthy financial position. A low ratio suggests that the business might face liquidity issues and should be evaluated carefully before investing.

It is important to note, however, that a high current ratio does not necessarily equate to good financial management. If a company’s current assets are tied up in slow-moving or obsolete inventory, its current ratio may be high without the company’s adequate liquidity for operational needs.

Synonyms

• Working Capital Ratio: The current ratio is also known as the ratio.
• Quick Ratio: The quick ratio, sometimes called the acid test, eliminates inventory from current assets and compares the remaining items (cash, receivables) to current liabilities. This measure is more rigorous than the current ratio.
• Liquidity Ratio: A liquidity measure similar to the current ratio, except it only factors the current assets an organization can liquidate within the upcoming 12 months, not all its current assets.

The Importance of the Current Ratio

The current ratio indicates a company’s financial health, so it has critical implications for investors, lenders, and accounting teams.

• Investors examine current obligations against the company’s assets to determine the risk involved in investing.
• Lenders use this ratio to decide whether they should approve and issue short-term debt and assess how quickly the company might be able to pay it back.
• Finance and accounting teams use financial ratios to analyze a company’s financial statements, understand current debts and assets, compare cash flow against industry benchmarks, adjust strategies to improve liquidity, and assess risk.
• Business owners and executives use the current ratio to determine the amount of money they can allocate towards expansion, investments, or other costs while still being able to meet their accounts payable obligations.

For example, if a company has a current ratio of 1.5—meaning its current assets exceed its current liabilities by 50%—it is in a relatively good position to pay off short-term debt obligations.

Conversely, if the company’s ratio is 0.8 or less, it may not have enough liquidity to pay off its short-term obligations.

If the organization needed to take out a loan or raise capital, it would likely have a much easier time in the first instance.

If a company cannot meet its immediate financial obligations, it must borrow or liquidate assets to make payments.

An organizational change (such as a new investor) or a restructuring program may be necessary in these cases.

Formula and Calculation for the Current Ratio

The formula for calculating the current ratio is:

Current Ratio = Current Assets ÷ Current Liabilities

It is expressed as a ratio and often rounded off to two decimal places, such as 2:1 or 2.25:1.

A ratio of 1:1 indicates that the firm has an equal amount of current assets and current liabilities.

If the current ratio is above 1, then it means that a company has sufficient assets to cover its liabilities.

A value below 1 may indicate that a firm lacks adequate liquidity and might face difficulty paying off its short-term debt.

Components of the Current Ratio Formula

Current ratio calculations comprise two main parts: current assets and current liabilities.

Current Assets

Current assets include liquid assets and those that can be liquidated within one year. Common examples of current assets include:

• Liquid cash (and cash equivalents): Cash, savings accounts, and checking accounts
• Financial securities: Money market funds, bonds, stocks, and short-term investments that can be sold on public exchanges.
• Accounts receivable: Money owed to the company by customers for goods or services provided.
• Inventory: Raw materials, components, and finished products that can be sold to consumers.
• Prepaid expenses: Payments made in advance for things such as rent, interest, insurance premiums, or taxes.
• Other current assets: Assets that aren’t common enough to have their own categories, such as the sale of real estate or equipment.

Current Liabilities

Current liabilities are those that must be paid within one year. Common examples of current liabilities include:

• Accounts payable: Payments owed to suppliers and vendors for goods or services purchased on credit.
• Short-term debt obligations: Bank loans, lines of credit, and other financial instruments that must be repaid in the next 12 months.
• Accrued expenses: Expenses that have been incurred but not yet paid, such as employee wages and taxes.
• Deferred revenue: Money that has been collected but not yet earned, such as monthly subscriptions or memberships.
• Other current liabilities: Liabilities that don’t fall into the above categories, such as unpaid franchise costs or royalties.

Example of How to Calculate the Current Ratio

When conducting a financial analysis using the current ratio, it is important to use the most reliable data sources.

If an organization’s financial statements show a current ratio of 2:1 but its bank statements indicate that it has more liabilities than assets, then the former figure should be disregarded.

This could happen in cases where the financial statements are outdated or erroneous.

Let’s look at a hypothetical current ratio example to demonstrate how the current ratio works.

Assume that a company has the following current assets:

• $2,500 in cash and other liquid assets
• $4,000 in accounts receivable
• $3,000 in inventory
• $1,000 in prepaid expenses

Its current liabilities are:

• $3,000 in accounts payable
• $1,500 in short-term debt

To calculate the current ratio:

• Current Assets = $2,500 + $4,000 + $3,000 + $1,000 = $10,500
• Current Liabilities = $3,000 + $1,500 = $4,500
• Current Ratio = $10,500 ÷ $4,500 = 2.33:1

In this case, the current ratio is 2.33:1, which indicates that the company has sufficient assets to cover its liabilities and should be able to pay all of its short-term obligations.

It is important to note that a current ratio of 2.33:1 may not always indicate a healthy financial situation since other factors should be taken into consideration as well.

The company’s long-term debt or ability to generate enough cash flow from operations could affect whether it can meet its short-term obligations in a timely manner.

Financial analysts and business owners should consider all available data when evaluating a company’s current ratio to make an informed decision.

What is a Good Current Ratio?

The higher a company’s current ratio is, the more capable it is of meeting its current liabilities.

Generally speaking, a ratio of 2:1 or higher indicates that the company can meet its short-term obligations if necessary.

Anything lower than 2:1 would be a cause for concern.

A ratio of 1.3, for instance, would suggest 1.3 times as many current liabilities as current assets, which could make it difficult for the company to pay off its debts in the near future.

But in the event of a financial crisis, this low of a ratio is far from ideal and would require the company to take drastic measures to avoid insolvency.

Example of Good Current Ratio

Assume that a company has the following current assets:

• $5,000 in cash and other liquid assets
• $6,000 in accounts receivable
• $4,500 in inventory
• $500 in prepaid expenses
• $2,000 from the sale of equipment

Its current liabilities are as follows:

• $3,500 in accounts payable
• $1,500 in short-term debt

To calculate the current ratio:

• Current Assets = $5,000 + $6,000 + $4,500 + $500 + $2,000 = $18,000
• Current Liabilities = $3,500 + $1,500 = $5,000
• Current Ratio = $18,000 ÷ $5,000 = 3.6:1

In this case, the current ratio is 3.6:1, which indicates that the company has 3.6 times its debt obligations in liquid (or close to liquid) assets and should be able to pay them off without any problems.

Example of Bad Current Ratio

Now, let’s look at an example of a company with a bad current ratio.

Assume that the same company has the following current assets:

• $2,000 in cash and other liquid assets
• $4,000 in accounts receivable
• $3,000 in inventory
• $1,500 in prepaid expenses

Its current liabilities include the following:

• $4,500 in accounts payable
• $5,000 in short-term debt
• $5,000 in deferred revenue

To calculate the current ratio:

• Current Assets = $2,000 + $4,000 + $3,000 + $1,500 = $10,500
• Current Liabilities = $4,500 + $5,000 + $5,000 = $14,500
• Current Ratio = $10,500 ÷ 14.500 = 0.73:1

In this case, the current ratio is 0.73:1, which indicates that the company does not have enough assets to cover its liabilities and may be unable to pay off its short-term debt obligations.

This warning sign should prompt further investigation into the company’s financial health.

How Companies Improve the Current Ratio

There are plenty of options for companies with low current ratios. Some of the most viable include:

• Working with creditors to reclassify debt. Reclassifying debt from short-term to long-term can help reduce current liabilities and improve the ratio.
• Increasing sales or generating more cash flow from existing operations. Improved revenue generation efforts give the company more liquid assets to cover its debts.
• Becoming more efficient. Through efficiency measures like process automation, companies can spend less money and use fewer resources to get the same work done.
• Improving inventory management. If a company can reduce its inventory levels, it can free up more cash to cover short-term liabilities.
• Delaying capital purchases that require cash payments. By avoiding big purchases, a company can conserve its cash and keep its current ratio steady.
• Cutting overhead expenses. Companies can save money by renegotiating supplier contracts, canceling useless services, moving offices to lower-cost areas, and downsizing where necessary.

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