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.
How to Calculate Current Ratio (Step-by-Step)
The current ratio is categorized as a liquidity ratio since it 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), Short-Term Debt
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.
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 ratio tends to also be a useful proxy for how efficient the company is at managing its working capital.
Current Ratio Formula
The formula for calculating the current ratio is as follows.
As a quick example calculation, suppose a company has the following balance sheet data:
- Cash = $25 million
- Marketable Securities = $20 million
- Accounts Receivable (A/R) = $10 million
- Inventory = $60 million
- Accounts Payables = $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 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.
- 1.5x to 3.0x: Company has sufficient current assets to pay off its current liabilities
- <1.0x: 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.