The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability to pay short-term liabilities (debt and payables) with its short-term 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.

  1. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
  2. What does high working capital say about a company's financial prospects?

    If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>
  3. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
  4. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  5. Does unearned revenue affect working capital?

    Unearned revenue, or deferred revenue, typically represents a company's current liability and affects its working capital ... Read Full Answer >>
  6. Do banks have working capital?

    The concept of working capital does not apply to banks since financial institutions do not have typical current assets and ... Read Full Answer >>
Related Articles
  1. Investing

    Using The Current Ratio

    Find out more on how this liquidity ratio is used to measure a company's ability to pay short-term obligations.
  2. Fundamental Analysis

    Reviewing Liabilities On The Balance Sheet

    As an experienced or new analyst, liabilities tell a deep story of how a company finances, plans and accounts for money it will need to pay at a future date.
  3. Fundamental Analysis

    Dynamic Current Ratio: What It Is And How To Use It

    Learn why this ratio may be a good alternative to the current, cash and quick ratios.
  4. Forex Education

    5 Tips For Reading A Balance Sheet

    The balance sheet, along with the income and cash flow statements, is an important tool for investors to gain insight into a company and its operations.
  5. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  6. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  7. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  8. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  9. Investing

    What’s the Difference Between Duration & Maturity?

    We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight.
  10. Fundamental Analysis

    Buy Penny Stocks Using the Wisdom of Peter Lynch

    Are penny stocks any better than playing penny slots in Vegas? What if you used the fundamental analysis principles of Peter Lynch to pick penny stocks?
  1. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
  2. Qualitative Analysis

    Securities analysis that uses subjective judgment based on nonquantifiable ...
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  4. Liquidity

    The degree to which an asset or security can be quickly bought ...
  5. Interest Coverage Ratio

    A debt ratio and profitability ratio used to determine how easily ...
  6. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center