The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability to pay shortterm liabilities (debt and payables) with its shortterm assets (cash, inventory, receivables). The current ratio is calculated by dividing current assets by current liabilities.
While current ratio can be used to evaluate a company’s financial health, the results can be misleading. One reason for this is that a high current ratio is not necessarily a good thing, and, similarly, a low current ratio is not automatically a bad thing. For example, assume company ABC has current assets of $1,000, current liabilities of $400 and a resulting current ratio of 2.5. Company XYZ, on the other hand, has current assets of $400, current liabilities of $400, and a resulting current ratio of 1.0. At first glance it may seem that company ABC is a better financial position to meets its obligations.
Let’s dig a little deeper. Assume both companies’ current liabilities have a payment period average of 30 days. Company ABC – with the higher current ratio – needs 180 days to collect its account receivables, and turns its inventory only twice per year. Company XYZ – with the lower current ratio – collects cash from its customers and turns its inventory 26 times per year. Despite the fact that XYZ has a lower ratio, it is in a better position and more liquid because of its faster cash conversion. Company ABC, though it has a higher current ratio, would have trouble operating because bills are coming in faster than cash.
The inventory component in the current ratio can also produce misleading results. For example, if a company’s current assets include a high percentage of inventory assets, the assets may be difficult to liquidate, and therefore, the company may not be as liquid as it appears in its current ratio.
As with other financial ratios, it is more useful to compare various companies within the same industry than to look at only one company, or to attempt to compare companies from different industries. In addition, investors should consider more than one ratio (or number) when making investment decisions since one figure cannot provide a comprehensive view of the company.

What is the formula for calculating the current ratio?
Find out how to calculate the current ratio and what that result can tell you about a potential investment. Read Answer >> 
What are some alternative liquidity ratios to the cash ratio?
Learn what the cash ratio measures, and understand what two other liquidity ratios can be used by a company to replace the ... Read Answer >> 
What are the main differences between the current ratio and the quick ratio?
Find out how the quick ratio and the current ratio can offer different views on a company's ability to pay off liabilities. Read Answer >> 
How can a company quickly increase its liquidity ratio?
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What is the relationship between the cash ratio and liquidity?
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To what extent should you take a company's liquidity ratio into account before investing ...
Find out how important it is for an investor to know a company's liquidity ratio before deciding to invest, and why relying ... Read Answer >>

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