What Is the Current Ratio?
The current ratio is a popular metric used across the industry to assess a company's short-term liquidity with respect to its available assets and pending liabilities. In other words, it reflects a company's ability to generate enough cash to pay off all its debts once they become due. It's used globally as a way to measure the overall financial health of a company.
While the range of acceptable current ratios varies depending on the specific industry type, a ratio between 1.5 and 3 is generally considered healthy. A ratio value lower than 1 may indicate liquidity problems for the company, though the company may still not face an extreme crisis if it's able to secure other forms of financing. A ratio over 3 may indicate that the company is not using its current assets efficiently or is not managing its working capital properly.
How to Calculate the Current Ratio
The current ratio is calculated using two standard figures that a company reports in it's quarterly and annual financial results which are available on a company's balance sheet: current assets and current liabilities. The formula to calculate the current ratio is as follows:
Current Ratio=Current LiabilitiesCurrent Assets
Components of the Current Ratio
Current assets can be found on a company's balance sheet and represent the value of all assets it can reasonably expect to convert into cash within one year. The following are examples of current assets:
For instance, a look at the annual balance sheet of leading American retail giant Walmart Inc. (WMT) for the fiscal year ending January 2018 reveals that the company had $6.76 billion worth of cash and short-term investments, $5.61 billion in total accounts receivable, $43.78 billion in inventory, and $3.51 billion in other current assets. Walmart's current assets for the period are the sum of these items on the balance sheet: $59.66 billion.
The current assets figure is different from a similar figure called total assets, which also includes net property, equipment, long-term Investments, long-term notes receivable, intangible assets, and other tangible assets.
Current liabilities are a company's debts or obligations that are due within one year, appearing on the company's balance sheet. The following are examples of current liabilities:
- Short-term debt
- Current portion of long-term debt
- Accounts payable
- Accrued liabilities like dividend, income tax, and payroll
For instance, for the fiscal year ending January 2018, Walmart had short-term debt of $5.26 billion, accounts payable worth $46.09 billion, other current liabilities worth $22.12 billion, and income tax payable worth $645 million. That brings Walmart's total current liabilities to $78.53 billion for the period.
Real-Life Examples of the Current Ratio
Based on the above-mentioned figures for Walmart, the current ratio for the retail giant is calculated as $59.66 / $78.52 = 0.76.
Similarly, technology leader Microsoft Corp. (MSFT) reported total current assets of $169.66 billion and total current liabilities of $58.49 billion for the fiscal year ending June 2018. Its current ratio comes to 2.90 ($169.66 / $58.49).
Investors and analysts would consider Microsoft's current ratio of 2.90 to be financially superior and healthy compared to Walmart's 0.76 because it indicates that the technology giant is better placed to pay off its obligations.
However, one must note that both companies belong to different industrial sectors and have different operating models, business processes, and cash flows that impact the current ratio calculations. Like with other financial ratios, the current ratio should be used to compare companies to their industry peers that have similar business models. Comparing the current ratios of companies across different industries may not lead to productive insights.
Using The Current Ratio
The current ratio is one of several measures that indicate the financial health of a company, but it's not the single and conclusive one. One must use it along with other liquidity ratios, as no single figure can provide a comprehensive view of a company.