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Written By:
Lisa Borga

## What is the Current Ratio?

The current ratio is an efficiency and liquidity ratio that assesses whether a company is able to pay for its current liabilities.

This ratio helps investors and other analysts to determine how liquid a company is as well as whether or not a business can meet its short-term financial obligations.

Generally, a current ratio is considered healthy if it is consistent with the average for its industry, only slightly higher.

If the current ratio is much higher than the average for its industry, it may indicate that the company is failing to make good use of its assets.

However, if it is lower than the average, this could indicate that the business may be at risk of default.

The current ratio only uses the dollar value of a company’s current assets and divides it by its liabilities.

This is also often known as the working capital ratio.

## The Formula for Calculating the Current Ratio

The current ratio is calculated by dividing a company’s current assets by its current liabilities.

Current assets can be found listed on a company’s balance sheet and include cash, marketable securities, prepaid expenses, and other assets that the company expects to sell or consume within a year.

Current liabilities consist of accounts, such as accrued liabilities, accounts payable, and income taxes payable.

The formula for calculating the current ratio is:

Current Ratio = Current Assets/Current Liabilities.

## Understanding the Current Ratio

The current ratio is a financial ratio that shows a business’s ability to pay off its short-term debts and other current liabilities with the current assets it has, such as cash or accounts receivable.

Often, companies with a current ratio below 1.00 do not have the capital necessary to pay their short-term obligations should they come due immediately.

Whereas companies that have a current ratio that is over 1.00 have the current assets necessary to meet their short-term liabilities.

This ratio shows a company’s liquidity at one point in time, so it does not give a complete picture of a company’s short-term solvency, nor is it reliable for determining a company’s long-term solvency.

For example, a business with a high current ratio may not be able to collect some accounts in accounts receivable in the short term and may even need to write some accounts off.

If too many accounts are aged or need to be written off, the company may not be very solvent even though it has a high current ratio.

It is important to consider the quality of a business’s current assets in addition to their value when comparing them to current liabilities.

A company that may be unable to collect their receivables or sell their inventory could be in danger of becoming insolvent and yet still have a high current ratio.

## How to Interpret the Current Ratio

If a company has a current ratio that is below 1.0, then its current liabilities are greater than its current assets.

Current liabilities are liabilities that are due in a year or less.

Current assets are cash or assets that are expected to be sold or used within a year.

A company with a current ratio below 1.00 may have trouble meeting its current obligations.

However, a company with this current ratio could have good long-term prospects.

There are a number of reasons a company could have a low current ratio.

Additionally, although a company may not be able to meet its short-term obligations when the current ratio is calculated,  the company may be able to pay the debts when they are due.

Also, if a company doesn’t give credit to customers, it can cause the payables balance on the balance sheet to seem high compared to the receivables balance.

Another issue that can cause a low current ratio is keeping a low inventory volume, which is sometimes done by large retailers with efficient supply chains.

It is generally thought that if a company has a higher current ratio, it will be better able to pay its current obligations.

This is due to the fact that companies with a higher current ratio have more current assets as compared to current liabilities.

But, a current ratio that is too high, such as more than three, could indicate that the company is not using its assets efficiently, doing a good job of obtaining financing, or effectively using the working capital it has.

The current ratio is useful for measuring the short-term solvency of a business if it is compared to the current ratio that is historically normal for the business and other businesses in its industry.

It can also be a good idea to make several calculations during different periods.

## Changes in the Current Ratio Over Time

A good way to determine whether or not a current ratio is good or not is by looking at how it has changed over time.

It’s possible for a company with a poor current ratio to be trending toward a good current ratio or for a company with a good current ratio to be moving toward a poor current ratio.

A company with a current ratio that is getting worse may lose value.

In contrast, a company that has a current ratio that is improving may have an undervalued stock and be a good investment.

If there are two companies and both have a current ratio of one, investors should look at the trend in their current ratios to determine which is more solvent.

For example, Pickles Inc. has a current ratio that has gone from .65 to .77 to .92 to 1.00, and Cheese Co.has a current ratio that went from 1.17 to 1.23 to 1.07 to 1.00.

The pickle company has had a positive trend and may be better able to meet its obligations.

This means it may be undervalued and worth investing in.

The cheese company has been experiencing a negative trend, which means the company may suffer from increased volatility and may decline in value.

 2015 2016 2017 2018 Pickles Inc. 0.65 0.77 0.92 1 Cheese Co. 1.17 1.23 1.07 1

## Examples of Using the Current Ratio

Here are some examples of current ratios.

General Dynamics has a current ratio of 1.48.

This means the company has \$1.48 in current assets for every \$1.00 in current liabilities.

This means the company should have enough current assets to cover its current liabilities.

Perspective has a current ratio of .84.

This indicates that the company has \$.84 of current assets for every \$1.00 in current liabilities.

This means the company may have problems paying its current liabilities.

## Other Liquidity Ratios

It is often a good idea to use other liquidity ratios in addition to the current ratio.

Other ratios can be a helpful addition when evaluating a company’s current assets as well as liabilities.

These ratios can help investors to learn more details about the current asset and liability accounts as well as how they are changing.

Liquidity tests, such as the quick ratio and another commonly used test, the acid-test ratio, help investors to compare assets in a company that is easy to liquidate to the company’s current liabilities.

Another liquidity ratio investors can use is the cash asset ratio, also known as the cash ratio, which is quite similar to the current ratio.

However, unlike the current ratio, it is limited to comparing a business’s cash along with its marketable securities to the current liabilities of the business.

There is also the operating cash flow ratio.

This ratio compares the amount of cash that is earned through operations to current liabilities.

Typically, investors prefer an operating cash flow ratio that is greater than one because this would indicate that the company has enough earnings to pay its current liabilities and still have some remaining earnings.

## Limitations of the Current Ratio

The current ratio does have limits.

It is not always useful when comparing businesses that are in very different industries from each other.

One area in which industries can vary significantly is in how they extend credit. Some industries tend to depend primarily on collecting payments in a short period of time.

At the same time, other industries may tend to offer long-term credit of ninety days or more to their customers.

Oddly enough, industries that tend to offer long-term credit to their customers could have a better current ratio due to the current assets tending to be higher competing companies in the same industry, which will yield better results.

Another problem that could occur when using the current ratio is that it is not specific.

The current ratio includes all of the current assets a company has, even if they would not be easy to liquidate. An example of this would be two companies with a current ratio of .70.

This may appear to be the same, but that is not necessarily the case.

These companies’ current assets could be quite different in quality as well as liquidity.

For example, Company 1 may have a number of short-term investments in its current assets.

Whereas, Company two predominately has cash.

The short-term. Investments could be difficult to liquidate in some cases quickly and may even impose penalties for early withdrawal, which could lower the value of the assets.

These two companies could have the same amount of current assets, but Company 2 would be more easily liquidated.

Company 1 and 2 also have different current liabilities.

Company 1 has current liabilities consisting primarily of notes payable.

In contrast, Company 2 has a large number of wages payable.

This means that Company 1 will likely have its current liabilities paid off first.

So, although both companies have a current ratio of .70, Company 1 is probably more solvent.

Therefore, it is good to use other ratios in addition to the current ratio when considering an investment in a company.

## What is a Good Current Ratio?

A good current ratio is not the same for every industry.

Instead, it is based on the historical performance of the industry the business is in.

But, if a company has a current ratio that is less than one, it could show that the company may have difficulty fulfilling any short-term commitments.

In contrast, a current ratio that is 1.5 or above would typically mean that a company should be able to meet its short-term liabilities.

## Calculating the Current Ratio

It is not difficult to calculate the current ratio.

Take the sum of the value of all of the assets and divide this by the sum of the value of all the current liabilities.

Current assets consist of all of a company’s assets that are expected to be used, sold during the current fiscal year or operating cycle.

This includes items such as supplies, cash, or prepaid expenses.

Current liabilities include things like income taxes payable, accounts payable, and short-term loans payable.

## What is Indicated by a Current Ratio of 2.0?

If a company has a ratio of 2.0, it means the company possesses current assets valuing \$2.00 for every \$1.00 in liabilities it has.

As an example, consider a company that has current assets of cash valuing \$75,000, accounts receivable of \$125,000, and an inventory of \$200,000.

The company also has current liabilities of \$175,000 in accounts payable and \$25,000 in wages payable.

Using this information to calculate the company’s current ratio would result in a 2.0.

This was calculated by dividing the current assets by the current liabilities. (\$75,000 + \$125,000 + \$200,000)/(\$175,000 + \$25,000)

## Key Takeaways

• The current ratio is a comparison of the current assets of a company to its current liabilities.
• Current assets are assets that are either cash or that the company believes will be used or liquidated within the year.
• Investors can use the current ratio to learn more about a company’s ability to use its current assets to meet its current short-term obligations.
• There are some weaknesses to the current ratio, including that it represents past data with no ability to forecast future trends, it is difficult to compare against other industry groups, and it fails to take factors outside of the balance sheet into account.

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1. Kansas City Community College " Current Ratio" Page 1 . November 29, 2021

2. Michigan State University "Financial Ratios Part 1 of 21: The Current Ratio" Page 1 . November 29, 2021

3. Mercury Colleges "Financial Ratios" Page 1 . November 29, 2021