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## What Is the Current Ratio?

• Formula and Calculation

## Understanding the Current Ratio

• Interpretation
• How It Changes Over Time
• Current Ratio vs. Other Ratios
• Limitations

## The Bottom Line

• Corporate Finance
• Financial Ratios

## Current Ratio Explained With Formula and Examples

The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.

A current ratio that is in line with the industry average or slightly higher is generally considered acceptable. A current ratio that is lower than the industry average may indicate a higher risk of distress or default . Similarly, if a company has a very high current ratio compared with its peer group, it indicates that management may not be using its assets efficiently.

The current ratio is called current because, unlike some other liquidity ratios, it incorporates all current assets and current liabilities . The current ratio is sometimes called the working capital ratio.

## Key Takeaways

• The current ratio compares all of a company’s current assets to its current liabilities.
• These are usually defined as assets that are cash or will be turned into cash in a year or less and liabilities that will be paid in a year or less.
• The current ratio helps investors understand more about a company’s ability to cover its short-term debt with its current assets and make apples-to-apples comparisons with its competitors and peers.
• One weakness of the current ratio is its difficulty of comparing the measure across industry groups.
• Others include the overgeneralization of the specific asset and liability balances, and the lack of trending information.

Investopedia / Lara Antal

## Formula and Calculation for the Current Ratio

To calculate the ratio, analysts compare a company’s current assets to its current liabilities.

Current assets listed on a company’s balance sheet include cash , accounts receivable , inventory , and other current assets (OCA) that are expected to be liquidated or turned into cash in less than one year.

Current liabilities include accounts payable , wages, taxes payable, short-term debts, and the current portion of long-term debt.

Current Ratio = Current assets Current liabilities \begin{aligned} &\text{Current Ratio}=\frac{\text{Current assets}}{ \text{Current liabilities}} \end{aligned} ​ Current Ratio = Current liabilities Current assets ​ ​

The current ratio measures a company’s ability to pay current, or short-term, liabilities (debts and payables) with its current, or short-term, assets, such as cash, inventory, and receivables.

In many cases, a company with a current ratio of less than 1.00 does not have the capital on hand to meet its short-term obligations if they were all due at once, while a current ratio greater than 1.00 indicates that the company has the financial resources to remain solvent in the short term. However, because the current ratio at any one time is just a snapshot, it is usually not a complete representation of a company’s short-term liquidity or longer-term solvency .

For example, a company may have a very high current ratio, but its accounts receivable may be very aged , perhaps because its customers pay slowly, which may be hidden in the current ratio. Some of the accounts receivable may even need to be written off. Analysts also must consider the quality of a company’s other assets vs. its obligations. If the inventory is unable to be sold , the current ratio may still look acceptable at one point in time, even though the company may be headed for default.

Public companies don't report their current ratio, though all the information needed to calculate the ratio is contained in the company's financial statements.

## Interpreting the Current Ratio

A ratio under 1.00 indicates that the company’s debts due in a year or less are greater than its assets—cash or other short-term assets expected to be converted to cash within a year or less. A current ratio of less than 1.00 may seem alarming, although different situations can negatively affect the current ratio in a solid company.

For example, a normal cycle for the company’s collections and payment processes may lead to a high current ratio as payments are received, but a low current ratio as those collections ebb. Calculating the current ratio at just one point in time could indicate that the company can’t cover all of its current debts , but it doesn’t necessarily mean that it won’t be able to when the payments are due.

Additionally, some companies, especially larger retailers such as Walmart, have been able to negotiate much longer-than-average payment terms with their suppliers. If a retailer doesn’t offer credit to its customers, this can show on its balance sheet as a high payables balance relative to its receivables balance. Large retailers can also minimize their inventory volume through an efficient supply chain , which makes their current assets shrink against current liabilities, resulting in a lower current ratio. Walmart’s current ratio as of January 31, 2023 was 0.82.

In theory, the higher the current ratio, the more capable a company is of paying its obligations because it has a larger proportion of short-term asset value relative to the value of its short-term liabilities. However, though a high ratio—say, more than 3.00—could indicate that the company can cover its current liabilities three times, it also may indicate that it is not using its current assets efficiently, securing financing very well, or properly managing its working capital .

The current ratio can be a useful measure of a company’s short-term solvency when it is placed in the context of what has been historically normal for the company and its peer group. It also offers more insight when calculated repeatedly over several periods.

## How the Current Ratio Changes Over Time

What makes the current ratio good or bad often depends on how it is changing. A company that seems to have an acceptable current ratio could be trending toward a situation in which it will struggle to pay its bills. Conversely, a company that may appear to be struggling now could be making good progress toward a healthier current ratio.

In the first case, the trend of the current ratio over time would be expected to harm the company’s valuation. Meanwhile, an improving current ratio could indicate an opportunity to invest in an undervalued stock amid a turnaround.

Imagine two companies with a current ratio of 1.00 today. Based on the trend of the current ratio in the following table, for which would analysts likely have more optimistic expectations?

Two things should be apparent in the trend of Horn & Co. vs. Claws Inc. First, the trend for Claws is negative, which means further investigation is prudent. Perhaps it is taking on too much debt or its cash balance is being depleted—either of which could be a solvency issue if it worsens. The trend for Horn & Co. is positive, which could indicate better collections, faster inventory turnover , or that the company has been able to pay down debt.

The second factor is that Claws’ current ratio has been more volatile , jumping from 1.35 to 1.05 in a single year, which could indicate increased operational risk and a likely drag on the company’s value.

## Example Using the Current Ratio

In its Q4 2022 fiscal results, Apple Inc. reported total current assets of $135.4 billion, slightly higher than its total current assets at the end of the last fiscal year of$134.8 billion. However, the company's liability composition significantly changed from 2021 to 2022. At the 2022, the company reported $154.0 billion of current liabilities, almost$29 billion greater than current liabilities from the prior period.

For 2021, Apple had more current assets than current liabilities. Its current ratio was ($134.836b /$125.481b) 1.075. This means that if all current liabilities of Apple were immediately due, the company could pay all of its bills without leveraging long-term assets.

## How Is the Current Ratio Calculated?

Calculating the current ratio is very straightforward: Simply divide the company’s current assets by its current liabilities. Current assets are those that can be converted into cash within one year, while current liabilities are obligations expected to be paid within one year. Examples of current assets include cash, inventory, and accounts receivable. Examples of current liabilities include accounts payable, wages payable, and the current portion of any scheduled interest or principal payments.

The current ratio is a useful liquidity measurement used to track how well a company may be able to meet its short-term debt obligations. It compares the ratio of current assets to current liabilities, and measurements less than 1.0 indicate a company's potential inability to use current resources to fund short-term obligations.

Accounting Tools. " Current Ratio Definition ."

Accounting Tools. " Current Asset Definition ."

Accounting Tools. " Current Liability Definition ."

Walmart. " Walmart Releases Q4 and FY23 Earnings ," Download Full Report, Page 6.

Apple. " Apple Reports Fourth Quarter Results ."

Duke University, Fuqua School of Business. " FSA Note: Summary of Financial Ratio Calculations ," Page 2.

• Guide to Financial Ratios 1 of 31
• What Is the Best Measure of a Company's Financial Health? 2 of 31
• What Financial Ratios Are Used to Measure Risk? 3 of 31
• Profitability Ratios: What They Are, Common Types, and How Businesses Use Them 4 of 31
• Understanding Liquidity Ratios: Types and Their Importance 5 of 31
• What Is a Solvency Ratio, and How Is It Calculated? 6 of 31
• Solvency Ratios vs. Liquidity Ratios: What's the Difference? 7 of 31
• Key Ratio: Meaning, Example, Pros and Cons 8 of 31
• Multiples Approach 9 of 31
• Return on Assets (ROA): Formula and 'Good' ROA Defined 10 of 31
• How Return on Equity Can Help Uncover Profitable Stocks 11 of 31
• Return on Investment (ROI): How to Calculate It and What It Means 12 of 31
• Return on Invested Capital: What Is It, Formula and Calculation, and Example 13 of 31
• EBITDA Margin: What It Is, Formula, How to Use It 14 of 31
• What is Net Profit Margin? Formula for Calculation and Examples 15 of 31
• Operating Margin: What It Is and the Formula for Calculating It, With Examples 16 of 31
• Current Ratio Explained With Formula and Examples 17 of 31
• Quick Ratio Formula With Examples, Pros and Cons 18 of 31
• Cash Ratio: Definition, Formula, and Example 19 of 31
• Operating Cash Flow (OCF): Definition, Types, and Formula 20 of 31
• Receivables Turnover Ratio Defined: Formula, Importance, Examples, Limitations 21 of 31
• Inventory Turnover Ratio: What It Is, How It Works, and Formula 22 of 31
• Working Capital Turnover Ratio: Meaning, Formula, and Example 23 of 31
• Debt-to-Equity (D/E) Ratio Formula and How to Interpret It 24 of 31
• Total-Debt-to-Total-Assets Ratio: Meaning, Formula, and What's Good 25 of 31
• Interest Coverage Ratio: Formula, How It Works, and Example 26 of 31
• Shareholder Equity Ratio: Definition and Formula for Calculation 27 of 31
• Can Investors Trust the P/E Ratio? 28 of 31
• Using the Price-to-Book (P/B) Ratio to Evaluate Companies 29 of 31
• Price-to-Sales (P/S) Ratio: What It Is, Formula To Calculate It 30 of 31
• Price-to-Cash Flow (P/CF) Ratio? Definition, Formula, and Example 31 of 31

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## What is current ratio and how to calculate it

updated September 1, 2023 · 3min read

## What is current ratio?

How to calculate current ratio, what is a good current ratio, current ratio limitations.

Current ratio is a measure of a company's liquidity, or its ability to pay its short-term obligations using its current assets. It's also a useful ratio for keeping tabs on an organization's overall financial health.

Here's what it is, how to calculate it, and how to interpret your results.

To understand your current ratio, you need to understand a couple of subtotals on your company's balance sheet .

• Current assets. Current assets are everything your company owns that you can reasonably expect to liquidate or turn into cash within one year. This normally includes cash and cash equivalents, prepaid expenses, accounts receivable , and inventory.
• Current liabilities. Current liabilities are obligations your company is expected to pay within one year. Examples of current liabilities include accounts payable, accrued expenses, and the portion of long-term debt due within the next 12 months.

Current ratio, also known as working capital ratio, shows a company's current assets in proportion to its current liabilities.

The formula for calculating current ratio is:

Current assets / current liabilities = current ratio

Dividing your total current assets by your total current liabilities determines how much of your current liabilities can be covered by your current assets.

For example, say your company's balance sheet shows the following current assets and current liabilities as of December 31, 2021:

Current assets:

• Cash: $150,000 • Accounts Receivable:$25,000
• Prepaid Expenses: $2,000 • Inventory:$75,000
• Total current assets: $252,000 Current liabilities: • Accounts payable:$20,000
• Accrued expenses: $7,000 • Short-term debt:$15,000
• Total current liabilities: $42,000 So, your current ratio on December 31, 2021, would be:$252,000 / $42,000 = 6 This means you could pay off your current liabilities with your current assets six times over. Ideally, you want a current ratio greater than one. This signals that you're in a strong position to pay your current obligations without taking on more debt or needing a cash infusion from shareholders or investors. A current ratio of less than one could indicate that your business has liquidity problems and may not be financially stable. There is no one-size-fits-all definition of a too-high current ratio. It depends on your business and the industry in which you operate. However, an excessively high current ratio may indicate that a company is hoarding cash instead of investing it into growing the business. In most industries, a current ratio between 1.5 and 3 is considered healthy. While keeping an eye on your current ratio can be helpful, it's not the only metric for measuring your company's short-term liquidity. Some other useful ratios include: ## Quick ratio Quick ratio is similar to the current ratio, but it does not include inventory in the numerator because inventory isn't always easily converted into cash. (Current assets – inventory) / current liabilities = quick Ratio ## Acid test ratio The acid test ratio is a variation of the quick ratio, but it doesn't include inventory or prepaid expenses in the numerator. (Current Assets – Prepaid Expenses – Inventory) / Current Liabilities = Acid Test Ratio ## Debt-to-equity ratio The debt-to-equity ratio divides total liabilities by total shareholder equity. This is a useful metric for comparing what a company owes (debt) to what it owns. Total liabilities / total shareholder equity = debt-to-equity ratio The cash ratio is the strictest measure of a company's liquidity because it only accounts for cash and cash equivalents in the numerator. Cash and cash equivalents / current liabilities = cash ratio Looking at any metric by itself or at a single point in time isn't a useful way to measure a company's financial health. Instead, it's important to consider other financial ratios in your analysis and look at those ratios over an extended period. This gives you a more accurate view of your company's liquidity and spot irregularities. by Janet Berry-Johnson A freelance writer with a background in accounting and income tax planning and preparation for individuals and small ... Read more... ## You may also like ## How to write a will Writing a will is one of the most important things you can do for yourself and for your loved ones, and it can be done in just minutes. Are you ready to get started? May 11, 2023 · 4min read ## What is a power of attorney (POA)? A comprehensive guide Setting up a power of attorney to make your decisions when you can't is a smart thing to do because you never know when you'll need help from someone you trust. October 23, 2023 · 14min read ## How to start an LLC in 7 steps: A complete guide for 2023 It's easy to create a new LLC by filing paperwork with the state. But to set yourself up for success, you'll also need to think about your business name, finances, an operating agreement, and licenses and permits. Here's a step-by-step guide. October 26, 2023 · 21min read ## How to Improve Current Ratio Current Ratio The operations current ratio is obtained by dividing total current assets by the total current liabilities and expressed as that result to one. Total current assets of$755,248 divided by total current liabilities $359,342 =2.10:1. For every one dollar of current debt the is 2.1 dollars of current assets. Current ratio measures the extent to which current assets if sold would pay off current liabilities. • A ratio greater than 1.60 is considered good. • A ratio less than 1.10 is considered poor. Working Capital The difference between total current assets and total current liabilities is called Working Capital. This tells us the operating capital available in the short term from within the business. Current Ratio and Working Capital are Liquidity Measures Liquidity is the ability of business to meet financial obligations as they come due. To have enough cash to pay your operating expenses, family living, taxes and all debt payments on time. Improving Current Ratio The operation can improve the current ratio and liquidity by: • Delaying any capital purchases that would require any cash payments • Looking to see if any term loans can be re-amortized • Reducing the personal draw on the business • Selling any capital assets that are not generating a return to the business (use cash to reduce current debt). ## Related Resources • Liquidity Ratios An accounting ratio is a mathematical relationship between two interrelated financial variables. Hence, Ratio analysis is the process of interpreting the accounting ratios meaningfully and taking decisions on this basis. Examples of most common ratios are Current Ratio, Equity Ratio, Debt to Equity Ratio, Fixed Assets Turnover Ratio, etc. ## Suggested Videos A business requires liquid funds in order to meet its short-term commitments. Liquidity is the ability of an organization to pay the amount as and when it becomes due, to the stakeholders . Thus, we need to calculate the Liquidity ratios to measure liquidity. These ratios are short-term in nature. The creditors always want to know the liquidity position of the entity because of their financial stake. When an organization is unable to fulfill its short-term commitments it adversely affects its credibility as well as the credit rating. Also, this may result in bankruptcy or closure. It is noteworthy here that excess and insufficient liquidity both are not good for the organization. ## Types of Liquidity Ratio Current ratio. • Quick Ratio or Acid test Ratio ## Cash Ratio or Absolute Liquidity Ratio Net working capital ratio. It is one of the most common ratios for measuring the short-term solvency or the liquidity of the firm. It is the ratio between the Current Assets and Current Liabilities. In other words, it measures whether there are enough current assets to pay the current debts with a margin of safety for potential losses in the realization of the current assets . Usually, the ideal current ratio is 2:1. However, the ideal ratio depends on the nature of the business and the characteristics of its current assets and current liabilities. Thus, $$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$ Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Cash-at-Bank + Receivables + Loans and Advances + Disposable Investments + Advance Tax Current Liabilities = Creditors + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + Dividend payable Learn more about Solvency Ratio here in detail . ## Quick Ratio It is also known as Acid-test Ratio. Quick Ratio measures the relationship between Quick Assets and Current Liabilities. It measures whether there are enough readily convertible quick funds to pay the current debts. Thus, it is better than the Current Ratio. Quick assets include only cash and near cash assets. It does not include inventories as they are not readily convertible into cash. $$\text{Quick Ratio or Acid-test Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}$$ Quick Assets = Current Assets – Inventories – Prepaid Expenses It measures the absolute liquidity of the firm. It measures whether a firm can pay the current debts by using only the cash balances, bank balances and marketable securities. We do not include Inventory and Debtors because there is no guarantee of their realization. Thus, $$\text{Cash Ratio} = \frac{\text{Cash and Bank Balances + Marketable Securities + Current Investments}}{\text{Current Liabilities}}$$ It is a measure of cash flow. The answer to this ratio should be positive. Usually, the bankers keep an eye on this ratio to see whether there is a financial crisis or not. Thus, • Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing) ## Solved Examples of Liquidity Ratios From the following particulars calculate the liquidity ratios: • $$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{490000}{350000} = 1.4:1$$ Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Bills Receivable = 280000 + 140000 + 50000 + 20000 Current Liabilities = Creditors + Bank Overdraft = 300000 + 50000 • $$\text{Quick Ratio or Acid-test Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} = \frac{350000}{350000} = 1:1$$ Quick Assets = Current Assets – Inventories = 490000 – 140000 • $$\text{Cash Ratio} = \frac{\text{Cash Balance}}{\text{Current Liabilities}} = \frac{50000}{350000} = 0.14:1$$ = 490000 – 300000 ## Accounting Ratios • Profitability Ratios • Ratio Analysis • Types of Ratios • Leverage Ratios • Acidity Ratios Which class are you in? Download the App • All Self-Study Programs • Premium Package • Basic Package • Private Equity Masterclass • Project Finance Modeling • FP&A Modeling (CFPAM™) • Buy-Side Financial Modeling • Bank & FIG Modeling • Oil & Gas Modeling • Biotech Sum of the Parts Valuation • The Impact of Tax Reform on Financial Modeling • VC Term Sheets & Cap Tables • Corporate Restructuring • The 13-Week Cash Flow Model • Real Estate Financial Modeling • REIT Modeling • Accounting Crash Course • Advanced Accounting • Crash Course in Bonds • Analyzing Financial Reports • Interpreting Non-GAAP Reports • Fixed Income Markets Certification (FIMC©) • Equities Markets Certification (EMC©) • ESG Investing • Excel Crash Course • PowerPoint Crash Course • Ultimate Excel VBA Course • Investment Banking "Soft Skills" • The Investment Banking Interview Guide ("The Red Book") • Virtual Boot Camps • 1:1 Coaching • Corporate Training • On-Campus Training • Free Content • Support/Contact Us • About Wall Street Prep ## Current Ratio Guide to Understanding the Current Ratio Learn Online Now ## What is Current Ratio? The Current Ratio is a measure of a company’s near-term liquidity position, or more specifically, the short-term obligations coming due within one year. Often used alongside the quick ratio, the current ratio measures if a company can meet its short-term obligations using its short-term assets on the present date. • The current ratio is a financial metric that measures the liquidity of a company by comparing the current assets belonging to a company to its current liabilities to determine if the liquid assets are sufficient to meet its short-term obligations coming due within twelve months (or one-year). • The current ratio formula is the current assets of a company divided by its current liabilities. • A current ratio of around 1.5x to 3.0x is considered to be healthy, whereas a current ratio below 1.0x is deemed a red flag that implies the near-term liquidity of the company presents risks. • The current ratio is different from the quick ratio because the metric is less conservative because the formula includes all current assets, rather than only those confirmed to be truly liquid. ## How to Calculate Current Ratio? The current ratio is categorized as a liquidity ratio, since the financial metric assesses how financially sound the company is in relation to its near-term liabilities . Liquidity ratios generally have a near-term focus, hence the two main inputs are current assets and current liabilities. • Current Assets → Cash and Cash Equivalents , Marketable Securities , Accounts Receivable (A/R), Inventory • Current Liabilities → Accounts Payable (A/P), Accrued Expense , Deferred Revenue (D/R), Short-Term Debt (<12 Month) The current ratio reflects a company’s capacity to pay off all its short-term obligations, under the hypothetical scenario that short-term obligations are due right now. ## Current Ratio Formula The formula to calculate the current ratio divides a company’s current assets by its current liabilities. Since the current ratio compares a company’s current assets to its current liabilities, the required inputs can be found on the balance sheet . Often, the current ratio tends to also be a useful proxy for how efficient the company is at working capital management. ## Current Ratio Calculation Example Suppose a company has the following balance sheet data: Current Assets: • Cash =$25 million
• Marketable Securities = $20 million • Accounts Receivable (A/R) =$10 million
• Inventory = $60 million Current Liabilities: • Accounts Payable (A/P) =$55 million
• Short-Term Debt = $60 million With that said, the required inputs can be calculated using the following formulas. • Current Assets =$25 million + $20 million +$10 million + $60 million =$115 million
• Current Liabilities = $55 million +$60 million = $115 million For the last step, we’ll divide the current assets by the current liabilities. • Current Ratio =$115 million ÷ $115 million = 1.0x The current ratio of 1.0x is right on the cusp of an acceptable value, since if the ratio dips below 1.0x, that means the company’s current assets cannot cover its current liabilities. If the ratio were to drop below the 1.0x “floor”, raising external financing would become urgent. ## What is a Good Current Ratio? The range used to gauge the financial health of a company using the current ratio metric varies on the specific industry. For instance, supermarket retailers typically have low current ratios considering their business model (and free cash flows) are essentially a function of their ability to raise more debt to fund asset purchases (i.e. increases debt on B/S), as well as pushing back supplier/vendor payments (i.e. increasing accounts payable) As a general rule of thumb, a current ratio in the range of 1.5 to 3.0 is considered healthy. • Current Ratio >1.5x → The company has sufficient current assets to pay off its current liabilities • Current Ratio = 1.0x → The company has sufficient current assets to meet its current liabilities, however, there is no margin for error (i.e. no “cushion”) • Current Ratio <1.0x → The company has insufficient current assets to pay off its current liabilities However, a current ratio <1.0 could be a sign of underlying liquidity problems, which increases the risk to the company (and lenders if applicable). Tracking the current ratio can be viewed as “worst-case” scenario planning (i.e. liquidation scenario) — albeit, the company’s business model may just require fewer current assets and comparatively more current liabilities. Here, the company could withstand a liquidity shortfall if providers of debt financing see the core operations are intact and still capable of generating consistent cash flows at high margins. But a higher current ratio is NOT necessarily always a positive sign — instead, a ratio in excess of 3.0x can result from a company accumulating current assets on its balance sheet (e.g. cannot sell inventory to customers). While under a liquidation scenario, a higher amount of asset collateral is perceived positively, most companies focus on forward-looking performance like free cash flow (FCF) generation and profit margins , although everything is linked to one another in some ways. ## What are the Limitations of Current Ratio? The limitations of the current ratio – which must be understood to properly use the financial metric – are as follows. • Minimum Cash Balance → One shortcoming of the metric is that the cash balance includes the minimum cash amount required for working capital needs. Without the minimum cash on hand for operations to continue, as usual, the business cannot continue to run if its cash were to dip below this level — e.g. the company is struggling to collect owed cash payments from customers that paid on credit. • Restricted Cash → Likewise, the cash balance could contain restricted cash , which is not freely available for use by the business and is instead held for a specific purpose. • Illiquid Short-Term Investments → Next, the inclusion of short-term investments that cannot be liquidated in the markets easily could also have been included — i.e. low liquidity and cannot sell without selling at a loss at a substantial discount. • Bad A/R (Uncollectable) → The last drawback to the current ratio that we’ll discuss is the accounts receivable amount can include “Bad A/R”, which is uncollectable customer payments, but management refuses to recognize it as such. ## Current Ratio vs. Quick Ratio: What is the Difference? Another practical measure of a company’s liquidity is the quick ratio , otherwise known as the “acid-test” ratio. The formula to compute the quick ratio is as follows. In comparison to the current ratio, the quick ratio is considered a more strict variation due to filtering out current assets that are not actually liquid — i.e. cannot be sold for cash immediately. By adjusting the numerator to include solely highly liquid assets that can truly be converted into cash in <90 days with a high degree of certainty, the quick ratio is a more conservative measure of liquidity. ## Current Ratio Calculator We’ll now move to a modeling exercise, which you can access by filling out the form below. ## 1. Balance Sheet Assumptions Suppose we’re tasked with analyzing the liquidity of a company with the following balance sheet data in Year 1. • Cash and Cash Equivalents =$20 million
• Marketable Securities = $15 million • Accounts Receivable (A/R) =$25 million
• Inventory = $65 million • Accounts Payable:$45 million
• Short-Term Debt: $80 million Putting the above together, the total current assets and total current liabilities each add up to$125m, so the current ratio is 1.0x as expected.

The company has just enough current assets to pay off its liabilities on its balance sheet.

## 2. Working Capital Calculation Example

As for the projection period – from Year 2 to Year 4 – we’ll use a step function for each B/S line item, with the Year 1 figures serving as the starting point.

Our assumptions for the changes in working capital line items are as follows.

• Cash and Cash Equivalents = +$5 million/Year • Marketable Securities = +$5 million/Year
• Accounts Receivable (A/R) = +$3 million/Year • Inventory = +$2 million/Year
• Accounts Payable (A/P) = –$3 million/Year • Short-Term Debt = –$2 million/Year

## 3. Current Ratio Calculation Example

Clearly, the company’s operations are becoming more efficient, as implied by the increasing cash balance and marketable securities (i.e. highly liquid, short-term investments), accounts receivable, and inventory.

By dividing the current assets balance of the company by the current liabilities balance in the coinciding period, we can determine the current ratio for each year.

From Year 1 to Year 4, the current ratio increases from 1.0x to 1.5x.

• Current Ratio – Year 1 = $125 million ÷$125 million = 1.0x
• Current Ratio – Year 2 = $140 million ÷$120 million = 1.2x
• Current Ratio – Year 3 = $155 million ÷$115 million = 1.3x
• Current Ratio – Year 4 = $170 million ÷$110 million = 1.5x

Note the growing A/R balance and inventory balance require further diligence, as the A/R growth could be from the inability to collect cash payments from credit sales .

The increase in inventory could stem from reduced customer demand, which directly causes the inventory on hand to increase — which can be good for raising debt financing (i.e. more collateral), but a potential red flag.

Therefore, applicable to all measures of liquidity, solvency , and default risk, further financial due diligence is necessary to understand the real financial health of our hypothetical company.

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Home Accounting Current Ratio – Formula & How Current Ratio Works with Example

Current Ratio – Formula & How Current Ratio Works with Example

## Yarab A | Updated on: May 18, 2022

--> published date: | updated on: --> <--, what is current ratio, how to calculate current ratio, significance of current ratio in a business, consequences of higher and lower current ratio, current ratio example with calculations, how do businesses prepare ratio analysis.

Ratio analysis is a study that determines and interprets numerical relationship based on financial statements. It is with the help of these techniques; the accounting ratios are derived from the financial statements.

Before we understand the current ratio, we need to know about liquidity ratios. Liquidity ratio analyses the short-term financial position of the firm to meet its short-term commitments (Current Liabilities) out of its short-term resources (Current Assets). It is also called as ‘solvency ratios.

In order to figure out the liquidity of the firm, the business uses the following techniques:

• Current ratio
• Liquidity ratio or quick asset ratio or acid test ratio

Let’s understand the current ratio and its significance in a business

Current ratio refers to a technique that measures the capability of a business to meet its short-term obligations that are due within a year. The current ratio considers the weight of the total current assets versus the total current liabilities.

In simple words, it illuminates how a business can maximize the liquidity of its current assets to settle debt and payables.

Going through the definition of the current ratio which is all about how much current assets are available to meet the company’s short-term debt (current liabilities), you arrive the following formula to calculate the current ratio.

In the above formula, the current ratio is derived by dividing current assets by current liabilities.

If you are curious to know the components of short-term assets and short-term liabilities, you should read our articles on Current Assets and Current Liabilities .

Are you wondering how to read 1.33:1? We have covered in the next section.

The current ratio indicates the availability of current assets in rupee for every one rupee of current liability. A ratio greater than 1 implies that the firm has more current assets than a current liability.

For example, a current ratio of 1.33:1 indicates 1.33 assets are available to meet the short-term liability of Rs. 1.

The significance of the current ratio is extremely important when a business is looking for financial help from the banks and financial institutions. This is one of key indicator which banks and financial institutions look for before lending the credit.

While considering the ideal current ratio of 2:1 , anything higher or lower indicates the following

• Higher current ratio indicates under trading and overcapitalization.
• A lower current ratio indicates over trading and undercapitalization.

Let us calculate current ratio of Kiran Enterprises considering the below example

The formula to arrive at the current ratio is as below

Current Ratio       =    Current Assets

______________

Current Liabilities

So, to apply the formula, you need to know the total of current assets and current liabilities. Let’s figure this out first using the information from the above table.

Now apply the formula to calculate current ratio.

Current Ratio        =      1,72,000

_________

1,03,500

=    1.662

A current ratio of Kiran Enterprises is 1.662: 1 which implies the firm has Rs. 1.662 of assets to cover every Rs. 1 in liability.

Ratio analysis helps the business owners to get the pulse of the organization quickly through ratios. Ratio Analysis acts as a dashboard of an organization in which all the key factors of a business is summarized in ratios.

While it is an important tool for business owners or decision makers but the time and efforts to determine such ratios is time-consuming. To mitigate this challenge and leverage the insights from ratio analysis, most of the businesses are using accounting software to generate such reports automatically.

Ratio Analysis Generated using Tally.ERP 9

## Why use the current ratio formula ?

Current ratio refers to the liquidity ratio that gauges an organization's capability to pay off short-term debts. It enables investors and analysts to understand how the venture is performing and can maximize the current assets on its balance sheet to fulfil its existing debt and payables.

## How the current ratio works?

The formula to calculate the current ratio is by dividing a company's current assets by its current liabilities.

## Limitations of the Current Ratio

One of the immediate limitations of the current ratio is that the ratio is not a satisfactory indicator to gauge a company's liquidity. A company cannot just depend on the current ratio since it provides very few details about its working capital.

## What is a good current ratio?

While the spectrum of a good current ratio differs basis the exact industry type, a ratio between 1.5 and 3 is considered healthy.

## Why high current ratio is bad?

Although a high current ratio is considered good, however, if the current ratio is too high, for instance, above 2, it might be that the organization is unable to utilize its current assets effectively.

## How do you fix a high current ratio?

Here are some of the ways to reduce high current ratio:

• Increase short term loans
• Expend cash optimally
• Leaner working capital model

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## What is Current Ratio? Guide with Examples

The current ratio is also called the liquidity ratio that measures a company's ability to meet short-term obligations or the obligations that expire within one year. It is to depict the short-term financial health of a company to investors, lenders, and analysts. It shows them how companies can maximize their current assets to pay off their current and other liabilities .

Here's what we have in store for you:

## Use of Current Ratio

What are current assets, what are current liabilities, understanding the current ratio.

• Changes in the Current ratio over time

## Current Ratio vs. Other Liquidity Ratios

Limitations on the use of current ratios.

• What is an ideal current ratio?
• What Does a Current Ratio of 1.5 Mean
• Significance of the current ratio

Understanding current ratio.

A current ratio that is above the industry average or in line with it is generally considered healthy. A current ratio below the industry average may indicate an increased risk of financial suffering or default. If a company's current ratio is very high compared to its peers, it can depict that the management may not be using its assets lucratively or efficiently.

The current ratio is an indicator of the current evaluation of all short-term assets and short-term liabilities, unlike other liquidity indicators. The current ratio is sometimes also referred to as the working capital ratio.

The current ratio formula and calculation of the current ratio helps analysts compare the company's current assets to the current liabilities.

Current assets that are listed on a company’s balance sheet include accounts receivable , inventory , cash, and other current assets (OCA) that are expected to be encashed or liquidated within a financial year.

Current liabilities include short-term debt, taxes, wages, accounts payable, and the short-term portion of long-term debt.

The formula to calculate the current ratio is

Current Ratio = Current assets/Current Liabilities

The total current assets of a company given on a date for a specified period include all assets that are expected to be liquidated within one year. Examples are:

• Cash – petty cash, coins, undeposited cheques, current and financial savings money accounts, Legal tender bills, etc.
• Cash equivalents – Corporate or authorities securities with a maturity of ninety days or less
• Prepaid expenses – Unexpired insurance premiums or advance payments on future purchases
• Office supplies – Office resources such as pens, paper, and equipment expected to be utilized within a financial year
• Accounts receivable – Money that the customers owe to the business which is recoverable within a year (deducting expected bad debts)
• Marketable securities – Preferred stock, Common stock, Government and corporate bonds maturity less than a year
• Notes receivable – Debt that will mature within a year
• Inventory – Work-in-process, Raw materials, finished goods, manufacturing or packaging supplies
• Other receivables – employee cash advances, insurance claims, income tax refunds

The total short-term debt of a company on a date that includes all business obligations payable within the year. Examples are:

• Notes payable – Interest and the principal amount of loans that will accrue within a year
• Accounts payable or Trade payable – Credit resulting from the purchase of raw materials, supplies, merchandise, or usage of services and other utilities
• Accrued expenses – Payroll taxes payable, interest payable, income taxes payable, and everything for which an invoice has not been generating but has been accrued for
• Deferred revenue – This is the revenue that has already been paid in advance to the company, which will be completed after meeting revenue recognition requirements

The current ratio calculates a company's capacity and potential to settle short-term debts or short-term liabilities using short-term or current assets such as inventories, cash, and accounts receivable.

• Companies with a current ratio that is less than 1.00 do not have the capital to meet their short-term debt when they are due at once
• On the other hand, if the current quota exceeds 1.00, it indicates that the company has the funds available to maintain its solvency

However, because the current ratio does not represent the bigger picture and is just a portrait of the current status of a company, and thus, it does not depict its long-term solvency or short-term liquidity.

## Let us take the real-life example of a big firm – Best Price

Large companies like Best Price, have been able to exhibit much longer-than-average payment terms with their dealers. If a supplier doesn't offer credit to its customers, this can show on its balance sheet as a high payables balance relative to its receivables balance.

Large retailers have the capability to reduce their inventory using an effective supply chain, that depicts their current assets lower as compared to their current liabilities, resulting in a lower current ratio.

Theoretically, it is believed that if the current ratio is high, it has more potential to pay its liabilities, as it has a good proportion of current assets as compared to the value of current liabilities that the company possesses for that specified period.

However, a high current ratio, say over 2.00, could indicate the company can cover its current liabilities two times, and may also indicate that it is not using its current assets efficiently, but securing funding or working capital very well.

The current ratio is a great tool to calculate a company’s short-term solvency when placed in a situation that was historically normal for the company and its peers. You can also get more insights by iterating it over multiple periods.

## Changes in the current ratio over time

Whether a current ratio is good or bad often depends on how it changes. There are chances that companies that appear to have a great current ratio may be heading into a situation where they are struggling to pay their invoices. On the contrary, there could be companies that appear to be struggling now may be well on their way to a better current ratio in the coming financial years.

In the first case, a situation like this can hamper the company's reputation while in the next case, improved current ratios may indicate a prospect to invest in undervalued stocks of that company.

## Let us take an example

We have two companies – Company X and Company Y and both have the same current ratio of 1.00.

Over time, company X is running too much debt or is running out of cash. If it gets worse, both can turn into solvency issues. On the other hand, consequently, company Y is seen in a positive trend, which may indicate faster turnover, better paybacks, or that the company was able to reduce debt.

Another factor to consider is that if the current ratio of a company – let’s say company X, in this case, is more volatile, and shifts from 1.35 to 1.05 in a year, it indicates increased operational risk and can undermine the value of the company.

Other similar liquidity metrics can complement the latest current analysis. It helps the investors understand the current state of a company's assets and liabilities from different angles and how these accounts change over time.

• The quick ratio , also known as the acid-test ratio, is a comparison of a company's easily liquidated assets to short-term liabilities. The liquidated assets include accounts receivable, cash, and short-term investments, excluding prepaid expenses and inventory
• The cash asset ratio or cash ratio is just like the current indicator, wherein the company's marketable securities and cash is compared to its short-term liabilities
• The operating cash flow ratio compares the active cash flow which is retrieved from CFO - the company's operating activities (CFO) to its short-term liabilities

Let us look at the limitations of current ratio:

## 1. When comparing different companies to each other

The current ratio figures are limited. Companies vary widely from industry to industry. Comparing current metrics from companies in different industries may not provide productive insights.

For example , in the manufacturing industry, it may be more common to give a customer 90 days or more of credit, but in the retail industry, short-term payback is more important. Paradoxically, the manufacturing company that is giving more credit days, may have a stronger current ratio because of higher assets or higher working capital. It usually makes more sense to compare companies in the same industry.

## 2. Another drawback of using the current ratios is that it isn’t specific

For example, There are two companies – A and B, and both have the same current ratio of 0.80 in each quarter. The situation of the companies may look similar, but the quality and liquidity of their assets can vary significantly in the following cases:

If company A has much more inventory than Company B which cannot be monetized in the short term. This inventory can be obsolete or undesirable and can ultimately reduce its value on the balance sheet.

If company B has more cash or more accounts receivable, that can be recovered faster than clearing the inventory. Even if the current assets remain the same for both the companies, yet company B will be in a more fluid and solvent condition.

If Company A and Company B have very different short-term debts. Company A has more accounts payable, whereas Company B has a higher amount in short-term debt or notes payable. In this situation, the accounts payable would need to be cleared before clearing the notes payable. In addition, the wages payable in the short-term of Company A are lower than the other company.

Both companies appear to be similar, but in this example, Company B may be in a more fluid and solvent position.

## What is the Ideal Current Ratio?

An ideal current ratio depends on the company's industry and historical development.

However, as a general rule, a current ratio below 1.00 indicates that a company may have difficulty achieving its short-term commitment, and a current ratio above 1.50 generally indicates enough liquidity.

## What Does a Current Ratio of 1.5 Mean?

A current ratio of 1.5 implies that the business enterprise has 1.50 of current assets for every $1.00 of current liabilities. For example, company A has cash worth$50,000 plus $100,000 in accounts receivable. Its present-day liabilities, of accounts payable, stands at$100,000. In this situation, the current ratio of company A will be 1.5, which is by dividing its current asset ($150,000) by its current liabilities ($100,000).

## Significance of the Current Ratio

• The current ratio is among the most important financial indicators that denote the liquidity of a company. It is one of the key financial metrics and is also called the liquidity ratio
• The current ratio is a major indicator to assess a company's business in terms of how robust the company is handling its outstanding debt
• Assessing the current ratio is imperative for creditors, corporate investors, top management of the company, and suppliers to make financial decisions. A current ratio is a fundamental tool for evaluating the feasibility of business profits

Below are the main strengths and weaknesses of calculating the current ratio:

• The current ratio is one of the easiest liquidity indicators which is quite simple and comprehensive to understand
• The current ratio will help you assess the operational cycle and the company's working capital needs in each quarter or financial period
• The calculation of the current ratio considers some of the non-liquid assets that cannot be converted into cash. The liquidity of these assets remains low which can affect the calculation of the current ratio
• The current ratio does not depict a meaningful comparison when it is compared between two companies belonging to different industries

The current ratio is a liquidity determinant that compares the total current assets to the short-term liabilities/debts of a company. This current ratio helps assess the short-term health and liquidity of a company. The current ratio is usually defined as assets that can be converted into cash within one year and liabilities that can be repaid within one year.

The current ratio helps the relevant stakeholders to better understand the position of a company and its ability to use working capital to meet short-term debt and compare it with peers. There are certain weaknesses while comparing current ratios across industry groups, like not getting access to recent information and the over-generalization of the balance between certain assets and liabilities. However, to date, the current ratio is an important parameter to calculate the immediate financial consistency of a company.

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## Key Takeaways

• The Current Ratio is an important indicator of a company's liquidity situation and is therefore highly considered by both analysts and investors
• As a rule of thumb, the current ratio should be more than 1, but it's recommended to compare it with similar companies belonging to the same industry for meaningful insights
• If the current ratio is below the industry average, it is considered acceptable or healthy
• However, a very high current ratio to the industry average may not be considered adequate as it essentially suggests that the company cannot use its assets efficiently
• Conversely, if your current ratio is well below the industry average, it may indicate a potential risk of default

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Home » Explanations » Financial statement analysis » Current ratio

## Current ratio

Current ratio  (also known as  working capital ratio ) is a popular tool to evaluate short-term solvency position of a business. Short-term solvency refers to the ability of a business to pay its short-term obligations when they become due. Short term obligations (also known as current liabilities ) are the liabilities payable within a short period of time, usually one year.

A higher current ratio indicates strong solvency position of the entity in question and is, therefore, considered better.

Current ratio is computed by dividing total current assets by total current liabilities of the business. This relationship can be expressed in the form of following formula or equation:

Above formula comprises of two components i.e., current assets and current liabilities. Both of these components should be available from the entity’s balance sheet . Some examples of current assets and current liabilities are listed below:

Some common examples of current assets are given below:

• Marketable securities
• Accounts receivables/debtors
• Inventories/stock
• Bills receivable
• Short-term totes receivable
• Prepaid expenses

Some common examples of current liabilities are given below:

• Accounts payable/creditors
• Bills payable
• Short-term notes payable
• Short term bonds payable
• Interest payable
• Unearned revenues
• current portion of long term debt

On December 31, 2016, the balance sheet of Marshal company shows the total current assets of $1,100,000 and the total current liabilities of$400,000. Your are required to compute current ratio of the company.

Current ratio = Current assets/Current liabilities = $1,100,000/$400,000 = 2.75 times

The current ratio is 2.75 which means the company’s currents assets are 2.75 times more than its current liabilities.

## Significance and interpretation

Current ratio is a useful test of the short-term-debt paying ability of any business. A ratio of 2:1 or higher is considered satisfactory for most of the companies but analyst should be very careful while interpreting it.  Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio may not always be a green signal. It requires a deep analysis of the nature of individual current assets and current liabilities. A company with high current ratio may not always be able to pay its current liabilities as they become due if a large portion of its current assets consists of slow moving or obsolete inventories. On the other hand, a company with low current ratio may be able to pay its current obligations as they become due if a large portion of its current assets consists of highly liquid assets i.e., cash, bank balance, marketable securities and fast moving inventories. Consider the following example to understand how the composition and nature of individual current assets can differentiate the liquidity position of two companies having same current ratio figure.

## Liquidity comparison of two or more companies with same current ratio

We may find situations where two or more companies have the same current ratio figures but their real liquidity position is far different from each other. It happens because of the quality and nature of individual items that make up the total current assets of the companies. Consider the following example to understand this point in more detail:

The following data has been extracted from the financial statements of two companies – company A and company B.

Both company A and company B have the same current ratio (2:1). Do both the companies have equal ability to pay its short-term obligations? The answer to this question is a “no” because company B is likely to have difficulties in paying its short-term obligations. Most of its current assets consist of inventory which might not be quickly convertible into cash. The company A, on the other hand, is likely to pay its current obligations as and when they become due because a large portion of its current assets consists of cash and receivables. Accounts receivable are generally considered more liquid assets in nature and thereby have a better chance to be quickly converted into cash than inventories.

The above analysis reveals that the two companies might actually have different liquidity positions even if both have the same current ratio number. While determining a company’s real short-term debt paying ability, an analyst should therefore not only focus on the current ratio figure but also consider the composition of current assets.

## Limitations of current ratio

Current ratio suffers from a number of considerable limitations and, therefore, can’t be applied as the sole index of liquidity. Some major limitations are given below:

## 1. Different ratio in different parts of the year:

The volume and frequency of trading activities have high impact on the entities’ working capital position and hence on their current ratio number. Many entities have varying trading activities throughout the year due to the nature of industry they belong. The current ratio of such entities significantly alters as the volume and frequency of their trade move up and down. In short, these entities exhibit different current ratio number in different parts of the year which puts both usability and reliability of the ratio in question.

## 2. Issues in inter-firm comparison:

Financial ratios are often made part of inter-firm comparison – a comparison of operating performance and financial status of two or more similar commercial entities working in the same industry, primarily conducted to learn and achieve a better business performance. To compare the current ratio of two companies, it is necessary that both of them use the same inventory valuation method. For example, comparing current ratio of two companies would be like comparing apples with oranges if one uses FIFO while other uses LIFO cost flow assumption for costing/valuing their inventories. The analyst would, therefore, not be able to compare the ratio of two companies even in the same industry.

## 3. Just a test of quantity, not quality:

Current ratio is a number which simply tells us the quantity of current assets a business holds in relation to the quantity of current liabilities it is obliged to pay in near future. Since it reveals nothing in respect of the assets’ quality, it is often regarded as crued ratio. For example, an entity with a favorable current ratio may still be at liquidity risk if it currently lacks on cash to settle its short-term liabilities and a bigger portion of its total current assests is composed of work in process inventories and slow moving stocks which generally require a longer period of time to bring cash in business.

## 4. Window dressing and manipulation:

Current ratio can be easily manipulated by equal increase or equal decrease in current assets and current liabilities numbers. For example, if current assets of a company are $10,000 and current liabilities are$5,000, the current ratio would be 2 : 1 as computed below:

$10,000 :$5,000 = 2 : 1

Now If both current assets and current liabilities are reduced by $1,000, the ratio would be increased to 2.25 : 1 as computed below:$9,000 : $4,000 = 2.25 : 1 Similarly if we increase both the elements by$1,000, the ratio would be decreased to 1.83 : 1 as computed below:

$11,000 :$6,000 = 1.83 : 1

However in order to minimize the impact of above mentioned limitations and to conduct a meaningful and reliable liquidity analysis of a business, the current ratio can be used in conjunction with many other ratios like inventory turnover ratio , receivables turnover ratio , average collection period , current cash debt coverage ratio , and quick ratio etc. These ratios are helpful in testing the quality and liquidity of a number of individual current assets and together with current ratio can provide much better insights into the company’s short-term financial solvency.

## Computating current assets or current liabilities when the ratio number is given

Students may come across examination questions or home work problems in which the examiner or tutor provideds a current ratio number along with some additional information pertaining to a business entity and asks them to work out either total current assets or total current liabilities figure. For example, he may provide current ratio and one of the total current assets or total current liabilities figure and ask the students to calculate the other one. There is no difficulty involved in computations like this, because we can work out either of the two figures just by rearranging the components of formula given above. Consider the two examples given below:

T & D company’s current ratio is 2.5 for the most recent period. If total current assets of the company are $7,500,000, what are total current liabilities? Current ratio = Current assets/Current liabilities or Current liabilities = Current assets/Current ratio =$7,500,000/2.5 = $3,000,000 If Marbel Inc’s current ratio is 1.4 and total current liabilities are$8,000,000, what are its total current assets?

Current ratio = Current assets/Current liabilities or Current assets = Current liabilities × Current ratio = $8,000,000 × 1.4 =$11,200,000

## Current Ratio Calculator

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