## 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 to 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.

### Key Takeaways

• 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.
• 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.
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## 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.

\begin{aligned} &\text{Current Ratio}=\frac{\text{Current assets}}{ \text{Current liabilities}} \end{aligned}

## 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.

A company with a current ratio less than 1.0 does not, in many cases, 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 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 very slowly, which may be hidden in the current ratio. Analysts must also consider the quality of a company’s other assets versus 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.

A current ratio of less than one may seem alarming, although different situations can affect the current ratio in a solid company. For example, a normal monthly 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 the company can’t cover all its current debts, but it doesn’t mean it won’t be able to once the payments are received.

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 in Jan. 2021 was 0.97.

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.

## Interpreting the Current Ratio

A ratio under 1.0 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.

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, while a high ratio, say over 3, could indicate the company can cover its current liabilities three times, it may also indicate that it's not using its current assets efficiently, is not securing financing very well, or is not managing its working capital.

## 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 where 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. An improving current ratio, meanwhile, could indicate an opportunity to invest in an undervalued stock in the midst of 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 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 likely drag on the company’s value.

## Example Using the Current Ratio

The current ratio for three companies—Apple, Walt Disney, and Costco Wholesale—is calculated as follows for the fiscal year ended 2017: