The current ratio is a popular metric used all across the industry to assess a company's short-term liquidity with respect to its available assets and the pending liabilities. The measure reflects a company's ability to generate enough cash to pay off all its debts once they become due. The current ratio is a globally adopted measure that indicates the overall financial health of a company and reflects the ability and preparedness of a business to liquidate its assets quickly to meet any pending obligations.
Formula to Calculate Current Ratio
The current ratio is computed using two standard figures of current assets and current liabilities. These values are reported in the quarterly and annual financial results and are available in the balance sheet. The current ratio is a proportion of current assets of a company to its current liabilities and is calculated by the following formula:
Components of the Current Ratio Calculation
Current Assets: Current assets are located on the balance sheet and represent the value of all assets that can reasonably expect to be converted 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 worth of total accounts receivable, $43.78 billion worth of Inventory and $3.51 billion worth of other current assets. Summing all these figures of the various assets held by Walmart leads to its current assets value of $59.66 billion.
One must note that current assets is different from other similar figure called total assets. The latter is a super-set of the former and additionally includes net property, plant & equipment, long-term Investments, long-term note receivable, intangible assets and other tangible assets.
Current Liabilities: 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:
For instance, Walmart had short-term debt of $5.26 billion, current portion of long-term debt worth $4.41 billion, accounts payable worth $46.09 billion, other current liabilities worth $22.12 billion and income tax payable worth $645 million for the fiscal year ending January 2018. It brings Walmart's total current liabilities to $78.52 billion.
Example of the Current Ratio
Based on the above mentioned figures for Walmart, the current ratio for the retail major is calculated as (Current Assets / Current Liabilities) = $59.66 / $78.52 = 0.7598 = 75.98%.
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 ($169.66 / $58.49) = 2.90 = 290.07%.
Investors and analysts would consider Microsoft's current ratio of 2.90 to be financially superior and healthy compared to Walmart's 0.7598, indicating the technology giant is better placed to pay off its obligations. However, one must note that both the companies belong the different industrial sectors, and have different operating models, business processes and cash flows which impact the current ratio calculations. It is advisable to use current ratio as a comparable measure for businesses which belong to the same industrial sector. Comparing the current ratios of companies across different industries may not lead to productive insights.
In general, the higher the current ratio, the better placed a business is for paying its obligations as it has a larger proportion of short-term asset value relative to the value of its short-term liabilities. However, a high ratio (over 3) may also indicate that the company is not using its current assets efficiently or is not managing its working capital properly. While the range of acceptable ratios vary 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 any extreme crisis as it may be be able to secure other forms of financing.
Using The Current Ratio
The Bottom Line
The current ratio provides investors insight as to whether a company has the ability to generate enough cash to pay off all debts should they become due simultaneously. The higher the ratio, the more current assets a company has at its disposal to pay off its obligations. Therefore, such liquidity ratios are more popular among the debt providers and creditors of a company as compared to the equity investors.
Like other financial ratios, the current ratio is recommended to be used to compare companies to their industry peers which have similar business models. Current ratio is one of the several measures that indicate the financial health of the company, but its 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.