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.