What Is the Current Ratio?
The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.
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 with its peer group, it indicates that management may not be using its assets efficiently.
The current ratio is called current because, unlike some other liquidity ratios, it incorporates all current assets and current liabilities. The current ratio is sometimes called the working capital ratio.
- 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 helps investors understand more about a company’s ability to cover its short-term debt with its current assets and make apples-to-apples comparisons with its competitors and peers.
- One weakness of the current ratio is its difficulty of comparing the measure across industry groups.
- Others include the overgeneralization of the specific asset and liability balances, and the lack of trending information.
Using The Current Ratio
Formula and Calculation for the Current Ratio
To calculate the ratio, analysts compare a company’s current assets to its current liabilities.
Current assets listed on a company’s balance sheet include cash, accounts receivable, inventory, and other current assets (OCA) that are expected to be liquidated or turned into cash in less than one year.
Current liabilities include accounts payable, wages, taxes payable, short-term debts, and the current portion of long-term debt.
Current Ratio=Current liabilitiesCurrent assets
Understanding the Current Ratio
The current ratio measures a company’s ability to pay current, or short-term, liabilities (debts and payables) with its current, or short-term, assets, such as cash, inventory, and receivables.
In many cases, a company with a current ratio of less than 1.00 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 1.00 indicates that the company has the financial resources 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 short-term liquidity or longer-term solvency.
For example, a company may have a very high current ratio, but its accounts receivable may be very aged, perhaps because its customers pay slowly, which may be hidden in the current ratio. Some of the accounts receivable may even need to be written off. Analysts also must consider the quality of a company’s other assets vs. its obligations. If the inventory is unable to be sold, the current ratio may still look acceptable at one point in time, even though the company may be headed for default.
Public companies don't report their current ratio, though all the information needed to calculate the ratio is contained in the company's financial statements.
Interpreting the Current Ratio
A ratio under 1.00 indicates that the company’s debts due in a year or less are greater than its assets—cash or other short-term assets expected to be converted to cash within a year or less. A current ratio of less than 1.00 may seem alarming, although different situations can negatively affect the current ratio in a solid company.
For example, a normal cycle for the company’s collections and payment processes may lead to a high current ratio as payments are received, but a low current ratio as those collections ebb. Calculating the current ratio at just one point in time could indicate that the company can’t cover all of its current debts, but it doesn’t necessarily mean that it won’t be able to when the payments are due.
Additionally, some companies, especially larger retailers such as Walmart, have been able to negotiate much longer-than-average payment terms with their suppliers. If a retailer doesn’t offer credit to its customers, this can show on its balance sheet as a high payables balance relative to its receivables balance. Large retailers can also minimize their inventory volume through an efficient supply chain, which makes their current assets shrink against current liabilities, resulting in a lower current ratio. Walmart’s current ratio as of January 31, 2023 was 0.82.
In theory, the higher the current ratio, the more capable a 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, though a high ratio—say, more than 3.00—could indicate that the company can cover its current liabilities three times, it also may indicate that it is not using its current assets efficiently, securing financing very well, or properly managing its working capital.
The current ratio can be a useful measure of a company’s short-term solvency when it is placed in the context of what has been historically normal for the company and its peer group. It also offers more insight when calculated repeatedly over several periods.
How the Current Ratio Changes Over Time
What makes the 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 toward a situation in which it will struggle to pay its bills. Conversely, a company that may appear to be struggling now could be making good progress toward a healthier current ratio.
In the first case, the trend of the current ratio over time would be expected to harm the company’s valuation. Meanwhile, an improving current ratio could indicate an opportunity to invest in an undervalued stock amid 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, for which would analysts likely have more optimistic expectations?
|Horn & Co.||0.75||0.88||0.93||0.97||0.99||1.00|
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 it is taking on too much debt or its 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 a likely drag on the company’s value.
Example Using the Current Ratio
In its Q4 2022 fiscal results, Apple Inc. reported total current assets of $135.4 billion, slightly higher than its total current assets at the end of the last fiscal year of $134.8 billion. However, the company's liability composition significantly changed from 2021 to 2022. At the 2022, the company reported $154.0 billion of current liabilities, almost $29 billion greater than current liabilities from the prior period.
For 2021, Apple had more current assets than current liabilities. Its current ratio was ($134.836b / $125.481b) 1.075. This means that if all current liabilities of Apple were immediately due, the company could pay all of its bills without leveraging long-term assets.
At the end of 2022, it was a slightly different story. Apple's current ratio was ($135.405b / $153.982b) 0.88. This means that Apple technically did not have enough current assets on hand to pay all of its short-term bills. Analysts may not be concerned due to Apple's ability to churn through production, sell inventory, or secure short-term financing (with its $217 billion of non-current assets pledged as collateral, for instance).
Current Ratio vs. Other Liquidity Ratios
Other similar liquidity ratios can supplement a current ratio analysis. In each case, the differences in these measures can help an investor understand the current status of the company’s assets and liabilities from different angles, as well as how those accounts are changing over time.
The commonly used acid-test ratio, or quick ratio, compares a company’s easily liquidated assets (including cash, accounts receivable, and short-term investments, excluding inventory and prepaid expenses) to its current liabilities. The cash asset ratio, or cash ratio, also is similar to the current ratio, but it only compares a company’s marketable securities and cash to its current liabilities.
Companies may use days sales outstanding to better understand how long it takes for a company to collect payments after credit sales have been made. While the current ratio looks at the liquidity of the company overall, the days sales outstanding metric calculates liquidity specifically to how well a company collects outstanding accounts receivables.
Finally, the operating cash flow ratio compares a company’s active cash flow from operating activities (CFO) to its current liabilities. This allows a company to better gauge funding capabilities by omitting implications created by accounting entries.
The current ratio is most useful when measured over time, compared against a competitor, or compared against a benchmark.
Limitations of Using the Current Ratio
One limitation of the current ratio emerges when using it to compare different companies with one another. Businesses differ substantially among industries; 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 actually may have a superficially stronger current ratio because its current assets would be higher. It is usually more useful to compare companies within the same industry.
Another drawback of using the current ratio, 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 that both have a current ratio of 0.80 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 eventually may 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 liquidating inventory. Although the total value of current assets matches, 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 in 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. Company A also has fewer wages payable, which is the liability most likely to be paid in the short term.
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.
What Is a Good Current Ratio?
What counts as a good current ratio will depend on the company’s industry and historical performance. Current ratios of 1.50 or greater would generally indicate ample liquidity.
What Happens If the Current Ratio Is Less Than 1?
As a general rule, a current ratio below 1.00 could indicate that a company might struggle to meet its short-term obligations, whereas ratios of above 1.00 might indicate a company is able to pay its current debts as they come due. If a company's current ratio is less than one, it may have more bills to pay than easily accessible resources to pay those bills.
What Does a Current Ratio of 1.5 Mean?
A current ratio of 1.5 would indicate that the company has $1.50 of current assets for every $1 of current liabilities. For example, suppose a company’s current assets consist of $50,000 in cash plus $100,000 in accounts receivable. Its current liabilities, meanwhile, consist of $100,000 in accounts payable. In this scenario, the company would have a current ratio of 1.5, calculated by dividing its current assets ($150,000) by its current liabilities ($100,000).
How Is the Current Ratio Calculated?
Calculating the current ratio is very straightforward: Simply divide the company’s current assets by its current liabilities. Current assets are those that can be converted into cash within one year, while current liabilities are obligations expected to be paid within one year. Examples of current assets include cash, inventory, and accounts receivable. Examples of current liabilities include accounts payable, wages payable, and the current portion of any scheduled interest or principal payments.
The Bottom Line
The current ratio is a useful liquidity measurement used to track how well a company may be able to meet its short-term debt obligations. It compares the ratio of current assets to current liabilities, and measurements less than 1.0 indicate a company's potential inability to use current resources to fund short-term obligations.
Accounting Tools. "Current Ratio Definition."
Accounting Tools. "Current Asset Definition."
Accounting Tools. "Current Liability Definition."
Walmart. "Walmart Releases Q4 and FY23 Earnings," Download Full Report, Page 6.
Apple. "Apple Reports Fourth Quarter Results."
Duke University, Fuqua School of Business. "FSA Note: Summary of Financial Ratio Calculations," Page 2.
Guide to Financial Ratios
What Is the Best Measure of a Company's Financial Health?
What Financial Ratios Are Used to Measure Risk?
Profitability Ratios: What They Are, Common Types, and How Businesses Use Them
Understanding Liquidity Ratios: Types and Their Importance
What Is a Solvency Ratio, and How Is It Calculated?
Solvency Ratios vs. Liquidity Ratios: What's the Difference?
Return on Assets (ROA): Formula and 'Good' ROA Defined
How Return on Equity Can Help Uncover Profitable Stocks
Return on Investment (ROI): How to Calculate It and What It Means
Return on Invested Capital: What Is It, Formula and Calculation, and Example
EBITDA Margin: What It Is, Formula, How to Use It
What is Net Profit Margin? Formula for Calculation and Examples
Operating Margin: What It Is and the Formula for Calculating It, With Examples
Current Ratio Explained With Formula and Examples
Quick Ratio Formula With Examples, Pros and Cons
Cash Ratio: Definition, Formula, and Example
Operating Cash Flow (OCF): Definition, Types, and Formula
Receivables Turnover Ratio Defined: Formula, Importance, Examples, Limitations
Inventory Turnover Ratio: What It Is, How It Works, and Formula
Working Capital Turnover Ratio: Meaning, Formula, and Example
Debt-to-Equity (D/E) Ratio Formula and How to Interpret It
Total-Debt-to-Total-Assets Ratio: Meaning, Formula, and What's Good
Interest Coverage Ratio: Formula, How It Works, and Example
Shareholder Equity Ratio: Definition and Formula for Calculation
Can Investors Trust the P/E Ratio?
Using the Price-to-Book (P/B) Ratio to Evaluate Companies
Price-to-Sales (P/S) Ratio: What It Is, Formula To Calculate It
Price-to-Cash Flow (P/CF) Ratio? Definition, Formula, and Example