Current Ratio

Loading the player...

What is the 'Current Ratio'

The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations. To gauge this ability, the current ratio considers the current total assets of a company (both liquid and illiquid) relative to that company’s current total liabilities.

The formula for calculating a company’s current ratio, then, is:

Current Ratio = Current Assets / Current Liabilities

The current ratio is called “current” because, unlike some other liquidity ratios, it incorporates all current assets and liabilities.

The current ratio is also known as the working capital ratio.

BREAKING DOWN 'Current Ratio'

The current ratio is mainly used to give an idea of the company's ability to pay back its liabilities (debt and accounts payable) with its assets (cash, marketable securities, inventory, accounts receivable). As such, current ratio can be used to take a rough measurement of a company’s financial health. The higher the current ratio, the more capable the company is of paying its obligations, as it has a larger proportion of asset value relative to the value of its liabilities.

A ratio under 1 indicates that a company’s liabilities are greater than its assets and suggests that the company in question would be unable to pay off its obligations if they came due at that point. While a current ratio below 1 shows that the company is not in good financial health, it does not necessarily mean that it will go bankrupt. There are many ways for a company to access financing, and this is particularly so if a company has realistic expectations of future earnings against which it might borrow. For example, if a company has a reasonable amount of short-term debt but is expecting substantial returns from a project or other investment not too long after its debts are due, it will likely be able to stave off its debt. All the same, a current ratio below 1 is usually not a good sign.

On the other hand, a high ratio (over 3) does not necessarily indicate that a company is in a state of financial well-being either. Depending on how the company’s assets are allocated, a high current ratio may suggest that that company is not using its current assets efficiently, is not securing financing well or is not managing its working capital well. To better assess whether or not these issues are present, a liquidity ratio more specific than the current ratio is needed.

An example: assume that Big-Sale Stores has $2 billion in cash, $1 billion in securities, $4 billion in inventory, $2 billion in accounts receivable and $6 billion in liabilities. To calculate Big-Sale’s current ratio, you would take the sum of its various assets and divide them by its liabilities, for a current ratio of 1.5 (($2B + $1B + $4B + $2B) / $6B = $9B / $6B = 1.5). Big-Sale Stores, then, appears to have healthy financials.

The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. 

Limitations of 'Current Ratio'

No one ratio is a perfect gauge of a company’s financial health or of whether or not investing in a company is a wise decision. As such, when using them it is important to understand their limitations, and the same holds true for the current ratio.

One limitation of using the current ratio emerges when using the ratio to compare different companies with one another. Because business operations can differ substantially between industries, comparing the current ratios of companies in different industries with one another will not necessarily lead to any productive insight. For example, while in one industry it may be common practice to take on a large amount of debt through leverage, another industry may strive to keep debts to a minimum and pay them off as soon as possible. Companies within these two industries, then, could potentially have very different current ratios, though this would not necessarily indicate that one is healthier than the other because of their differing business practices. As such, it is always more useful to compare companies within the same industry.

Another drawback of using current ratios, briefly mentioned above, involves its lack of specificity. Of all of the different liquidity ratios that exist, the current ratio is one of the least stringent. Unlike many other liquidity ratios, it incorporates all of a company’s current assets, even those that cannot be easily liquidated. As such, a high current ratio cannot be used to effectively determine if a company is inefficiently deploying its assets, whereas certain other liquidity ratios can.

'Current Ratio' and Other Liquidity Ratios

Generally, liquidity ratios can be used to gauge a company’s ability to pay off its debts. However, there are a variety of different liquidity ratios that exist and that measure this in different ways. When considering the current ratio, it is important to understand its relationship to other popular liquidity ratios.

One popular ratio is the working capital ratio, which is the same as the current ratio.

Another class of liquidity ratios works in a similar way to the current ratio, but are more specific as to the kinds of assets they incorporate. The cash asset ratio (or cash ratio), for example, compares only a company’s marketable securities and cash to its current liabilities. The acid-test ratio (or quick ratio) compares a company’s easily liquidated assets (including cash, accounts receivable and short-term investments, excluding inventory and prepaids) to its current liabilities. The operating cash flow ratio compares a companies active cash flow from operations to its current liabilities. These liquidity ratios have a more specific purpose than the current ratio, that is, to gauge a company’s ability to pay off short term debts.

Another similar liquidity ratio is the debt ratio, which is the opposite of the current ratio. Debt ratio calculations take current liabilities as the numerator and current assets as the denominator in an attempt to measure a company’s leverage.

RELATED TERMS
  1. Cash Asset Ratio

    The current value of marketable securities and cash, divided ...
  2. Liquidity Ratios

    A class of financial metrics that is used to determine a company's ...
  3. Cash Ratio

    The ratio of a company's total cash and cash equivalents to its ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. ...
  5. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  6. Key Ratio

    A mathematical ratio that illustrates and summarizes the current ...
Related Articles
  1. Investing Basics

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
  2. Investing Basics

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  3. Trading Strategies

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  4. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  5. 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.
  6. Fundamental Analysis

    Financial Analysis: Solvency Vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health. A number of financial ratios are used to measure a company’s liquidity and solvency, and an investor should use ...
  7. Technical Indicators

    Key Financial Ratios to Analyze Tech Companies

    Understand the technology industry and the companies that operate in it. Learn about the key financial ratios used to analyze tech companies.
  8. Economics

    What is the Cash Ratio?

    The cash ratio is the ratio of a company's total cash and cash equivalents to its current liabilities.
  9. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  10. 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.
RELATED FAQS
  1. How can a company quickly increase its liquidity ratio?

    Discover what high and low values in the liquidity ratio mean and what steps companies can take to improve liquidity ratios ... Read Answer >>
  2. 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 >>
  3. 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 >>
  4. 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 >>
  5. How can the current ratio be misinterpreted by investors?

    Statistics can be misleading, and numbers on the balance sheet are no exception. Find out how the current ratio can confuse ... Read Answer >>
  6. What is the relationship between the cash ratio and liquidity?

    Understand the relationship between a company's cash ratio and its liquidity. Learn what the cash ratio measures and what ... Read Answer >>
Hot Definitions
  1. Physical Capital

    Physical capital is one of the three main factors of production in economic theory. It consists of manmade goods that assist ...
  2. Reverse Mortgage

    A type of mortgage in which a homeowner can borrow money against the value of his or her home. No repayment of the mortgage ...
  3. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  4. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  5. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  6. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
Trading Center