Table of Contents
- What Is the Current Ratio?
- Understanding the Current Ratio
- Formula and Calculation for the Current Ratio
- Using the Current Ratio
- Example of Current Ratio
- Current Ratio vs. Other Liquidity Ratios
- Limitations of the Current Ratio
- What Is a Good Current Ratio?
- What Happens If the Current Ratio Is Less Than 1.0?
- What Does a Current Ratio of 1.5 Mean?
- How Is the Current Ratio Calculated?
- The Bottom Line
What Is the Current Ratio?
Let me explain the current ratio directly: it's a liquidity ratio that shows whether a company can pay its current obligations. It tells you if the company can use its current assets on the balance sheet to cover debt payments and other payables due within a year.
If the ratio matches or slightly exceeds the industry average, that's generally fine. A lower ratio than the average points to a risk of financial distress or default. On the other hand, a much higher ratio compared to peers suggests management isn't using assets efficiently.
We call it the current ratio because it includes all current assets and liabilities, unlike some other ratios. You might also hear it referred to as the working capital ratio.
Key Takeaways
- The current ratio divides all of a company’s current assets by its current liabilities.
- It helps you understand a company’s ability to cover its short-term debt and bills.
- You can use it to compare a company to its competitors and peers.
- Industries have different expected or average current ratios, so don't use it to compare companies in different industries.
- Other limitations include the overgeneralization of specific asset and liability balances, as well as the lack of trending information.
Understanding the Current Ratio
You need to know if a business can pay what it owes, and that's where the current ratio comes in. It weighs current liabilities like debts and payables against current assets such as cash, inventory, and receivables.
A ratio under 1.00 often means the company lacks the capital to meet short-term obligations if they all come due at once. A ratio over 1.00 shows it has the resources to stay solvent short-term.
Remember, this is just a snapshot, so it's not a full picture of liquidity or long-term solvency. For instance, a high ratio might hide aged receivables that customers pay slowly, or even ones that need writing off.
You also have to consider asset quality—if inventory can't sell, the ratio might look good but the company could still default. Generally, a higher ratio means better ability to pay obligations, with more short-term assets relative to liabilities.
But a very high ratio, say over 3.00, could mean inefficient asset use, poor financing, or bad working capital management. That's why comparing to similar businesses in the same industry is key.
Public companies don't report their current ratio directly, but you can find all the info in their financial statements to calculate it.
Formula and Calculation for the Current Ratio
To calculate it, divide current assets by current liabilities. The formula is: Current Ratio = Current Assets / Current Liabilities.
Current assets on the balance sheet include cash, accounts receivable, inventory, and other assets expected to turn into cash within a year. Current liabilities cover accounts payable, wages, taxes payable, short-term debts, and the current part of long-term debt.
Using the Current Ratio
A ratio under 1.00 might alarm you, but one ratio alone doesn't give the full financial picture. For example, a company's normal collection and payment cycles could cause fluctuations—a high ratio when payments come in, low when they slow.
Calculating at one point might suggest it can't cover debts, but that doesn't mean it won't when payments are actually due. Large retailers often have long payment terms with suppliers, leading to high payables and low inventory, which lowers the ratio.
The ratio is useful when viewed in historical context for the company and its peers. Calculate it over several periods to see changes—that gives better insight.
A declining ratio might signal trouble ahead, hurting valuation. An improving one could mean an investment opportunity in an undervalued stock.
Example of Current Ratio
Consider two companies both with a current ratio of 1.00 today. They look the same at first, but trends matter. For Company A, the ratio went from 0.75 in 2020 to 0.88 in 2021, 0.93 in 2022, 0.97 in 2023, 0.99 in 2024, and 1.00 in 2025—steadily improving.
For Company B, it started at 1.25 in 2020, dropped to 1.17 in 2021, jumped to 1.35 in 2022, then 1.05 in 2023, 1.02 in 2024, and 1.00 in 2025—more volatile and declining overall.
Company B's negative trend suggests issues like too much debt or depleting cash, potentially a solvency risk. Company A's positive, stable trend indicates better collections, inventory turnover, or debt management, making its finances seem more stable.
Current Ratio vs. Other Liquidity Ratios
Other ratios can supplement your analysis. The acid-test or quick ratio compares easily liquidated assets like cash, receivables, and short-term investments (excluding inventory and prepaids) to current liabilities.
The cash ratio only uses marketable securities and cash against liabilities. Days sales outstanding shows how long it takes to collect after credit sales, focusing on receivable liquidity.
The operating cash flow ratio compares cash flow from operations to current liabilities, ignoring accounting entries for a better funding view.
Limitations of the Current Ratio
One issue is comparing across industries—different sectors have varying norms, like longer credit terms in some, which can inflate assets and the ratio.
The ratio lacks specificity by including all current assets, even hard-to-liquidate ones. For example, two companies with 0.80 ratios might differ: one with excess inventory that's hard to sell, another with more cash and receivables.
Liabilities vary too—more accounts payable might need faster payment than notes payable. Dig deeper with other ratios for a clearer picture. Measure the current ratio over time, against competitors, or benchmarks for best use.
What Is a Good Current Ratio?
It depends on the industry and history. Over 1.00 means assets exceed liabilities, enough to pay short-term debts. A ratio of 1.50 or higher usually shows ample liquidity.
What Happens If the Current Ratio Is Less Than 1.0?
Generally, below 1.00 suggests struggles to meet obligations, with more bills than accessible resources.
What Does a Current Ratio of 1.5 Mean?
It means $1.50 in current assets for every $1 in liabilities, appearing sufficient for obligations.
How Is the Current Ratio Calculated?
Divide current assets by current liabilities from the balance sheet. Assets are convertible to cash in a year; liabilities are due within a year, like payables and short-term debt portions.
The Bottom Line
The current ratio tracks how well a company can meet short-term debts by comparing assets to liabilities. Below 1.0 signals potential issues. Since these change, calculate yearly to spot positive or negative trends.
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