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 calculate the ratio, analysts compare current assets to current liabilities. Current assets include cash, accounts receivable, inventory and other assets that are expected to be turned into cash in less than a year. Current liabilities include accounts, wages, taxes payable, and the current portion of long-term debt. The formula for calculating a company’s current ratio is as follows:
Current Ratio = Current Assets / Current Liabilities
A current ratio that is in line with the industry average or slightly higher is generally considered acceptable. A current ratio that is lower than the industry average may indicate a higher risk of distress or default. Similarly, if a company has a very high current ratio compared to their peer group, it indicates that management may not be using their assets efficiently.
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.
Using The Current Ratio
BREAKING DOWN Current Ratio
A company with a current ratio less than one does not have the capital on hand to meet its short-term obligations if they were all due at once, while a current ratio greater than one indicates the company should be able to remain solvent in the short-term. However, because the current ratio at any one time is just a snapshot, it is usually not a complete representation of a company’s liquidity or solvency.
For example, a company may have a very high current ratio but their accounts receivable are low quality. Perhaps they have not been able to collect from their customers quickly which may be hidden in the current ratio. Analysts must also consider the quality of a company’s other assets versus its obligations as well. If inventory is unable to be sold, the current ratio may still look acceptable, but the company may be headed for default.
A current ratio that is less than one may seem alarming. However, what if there is a normal monthly cycle for the company’s collections and payment processes that leads to a high current ratio as payments are received and a low current ratio as those collections ebb? Just because the snapshot of the current ratio indicates the company can’t cover all its current debts, doesn’t mean it won’t be able to once the payments are due. Although there is some ambiguity, the current ratio can still be a useful measure of a company’s short-term solvency when it is placed in context of what has been historically normal for the company and its peer group.
Interpreting the Current Ratio
A ratio under 1 indicates that the company’s debts that will need to be paid in a year or less are greater than its assets (either cash or expected to be converted to cash within a year or less.) A current ratio less than one would not be concerning if the company has a much higher receivables turnover than payables turnover. For example, retail companies collect very quickly from consumers but have a long time to pay their suppliers. Because of this imbalance, a current ratio below 1 is normal within the industry group.
In theory, the higher the current ratio, the more capable the company is of paying its obligations because 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) could indicate the company is not using its current assets efficiently, is not securing financing very well, or is not managing its working capital.
Current Ratio in Practice
The current ratio for three companies – Apple (AAPL), Walt Disney (DIS), and Costco Wholesale (COST) – are calculated as follows for the fiscal year ended 2017:
Limitations of 'Current Ratio'For every $1 of current debt, COST had $.98 cents available to pay for the debt at the time this snapshot was taken. Likewise, Disney had $.81 cents in current assets for each dollar of current debt. Apple had more than enough to cover its current liabilities if they were all theoretically due immediately and all current assets could be turned into cash.
Limitations of 'Current Ratio'
One limitation of using the current ratio emerges when using the ratio to compare different companies with one another. Businesses differ substantially between industries, therefore comparing the current ratios of companies across different industries may not lead to productive insight.
For example, in one industry it may be more typical to extend credit to clients for 90-days or longer, while in another industry, short-term collections are more critical. Ironically, the industry that extends more credit may actually have a superficially stronger current ratio because their current assets would be higher. It is usually more useful to compare companies within the same industry.
Another drawback of using current ratios, briefly mentioned above, involves its lack of specificity. Unlike many other liquidity ratios, it incorporates all of a company’s current assets, even those that cannot be easily liquidated. For example, imagine two companies which both have a current ratio of .80 at the end of the last quarter. On the surface this may look equivalent but the quality and liquidity of those assets may be very different as shown in the following breakdown:
In this example Company A has much more inventory than Company B, which will be harder to turn into cash in the short-term. Perhaps this inventory is overstocked or unwanted, which may eventually reduce its value on the balance sheet. Company B has more cash, which is the most liquid asset and more accounts receivable which could be collected more quickly than inventory can be liquidated. Although the total value of current assets match, Company B is in a more liquid, solvent position.
The current liabilities of Company A and Company B are also very different. Company A has more accounts payable while Company B has a greater amount of short-term notes payable. This would be worth more investigation because it is likely that the accounts payable will have to be paid before the entire balance of the notes payable account. However, Company B does have fewer wages payable, which is the liability most likely to be paid in the short term.In this example Company A has much more inventory than Company B, which will be harder to turn into cash in the short-term. Perhaps this inventory is overstocked or unwanted, which may eventually reduce its value on the balance sheet. Company B has more cash, which is the most liquid asset and more accounts receivable which could be collected more quickly than inventory can be liquidated. Although the total value of current assets match, Company B is in a more liquid, solvent position.
In this example, although both companies seem similar, Company B is likely in a more liquid and solvent position. An investor can dig deeper into the details of a current ratio comparison by evaluating other liquidity ratios that are more narrowly focused than the current ratio.
Change in the Current Ratio Over Time
What makes a current ratio “good” or “bad” often depends on how it is changing. A company that seems to have an acceptable current ratio could be trending towards a situation where it will struggle to pay its bills. Inversely, a company that may appear to be struggling now, could be making good progress towards a healthier current ratio. In the first case, the trend of the current ratio over time would be expected to have a negative impact on the company’s value. An improving current ratio could indicate an opportunity to invest in an undervalued stock in a “turnaround”.
Imagine two companies with a current ratio of 1.00 today. Based on the trend of the current ratio in the following table, which would analysts likely have more optimistic expectations for?
Two things should be apparent in the trend of Horn & Co. vs. Claws, Inc.: First the trend for Claws is negative, which means further investigation is prudent. Perhaps they are taking on too much debt, or their cash balance is being depleted: either of which could be a solvency issue if it worsens. The trend for Horn & Co. is positive, which could indicate better collections, faster inventory turnover, or that the company has been able to pay down debt. The second factor is that Claws’ current ratio has been more volatile, jumping from 1.35 to 1.05 in a single year, which could indicate increased operational risk and likely drag on the company’s value.
'Current Ratio' and Other Liquidity Ratios
Other liquidity ratios can be used to supplement a current ratio analysis. In each case, these measures can help an investor understand the current status of the company’s assets and liabilities as well as how those accounts are changing over time.
Cash asset ratio (or cash ratio): Compares only a company’s marketable securities and cash to its current liabilities.
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.
Operating cash flow ratio: Compares a company’s active cash flow from operations to its current liabilities.
Current Ratio Summary
The current ratio compares all of a company’s current assets to its current liabilities. These are usually defined as assets that are cash or will be turned into cash in a year or less, and liabilities that will be paid in a year or less. The current ratio is sometimes referred to as the “working capital” ratio and helps investors understand more about a company’s ability to pay its short-term debt. Some weaknesses of the current ratio include the difficulty of comparing the measure across industry groups, overgeneralization of the specific asset and liability balances, and the lack of trending information.