The current ratio, also commonly referred to as the working capital ratio, evaluates whether a company can cover its current liabilities with its current assets. The current ratio formula divides a company’s current assets by its current liabilities. It’s a useful calculation that can be used to determine if a company can pay its short-term obligations based on the value of its current assets within a year.
A higher current ratio indicates better short-term financial health, with a ratio of better than 1.0 indicating that a company has enough short-term liquidity.
Current Ratio Calculator
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Current Ratio Formula
The current ratio formula is:
Current Ratio | = | Current Assets |
Current Liabilities |
Current Assets
Current assets are defined as balance sheet items that can quickly be converted into cash within one year. Inclusive of liquid assets, examples of current assets include the following:
- Cash: Cash includes any funds held in checking or savings accounts, any petty cash, and any bank drafts or money orders.
- Cash equivalents: Cash equivalents are any short-term promissory notes owed to the company as well as marketable securities, short-term government bonds, and treasury bills.
- Accounts receivable (A/R): This includes any money owed by customers for purchases of goods or services that were made on credit.
- Inventory: Any assets held by a company that are intended to be sold to end-users. This can include both finished products as well as raw materials that will be used in the manufacture of a company’s products.
What’s Excluded From Current Assets
Exceptions to current assets are assets that aren’t able to be converted into cash within a year. Generally, these are known as fixed assets. They include the following:
- Property: Property includes any buildings, land, or other commercial real estate held by a business.
- Equipment: Equipment includes any machinery, technology such as computers and servers, and other equipment not considered a part of the company’s inventory.
- Vehicles: Vehicles are any cars, trucks, or other titled vehicles owned by a company and not considered a part of its inventory.
Current Liabilities
Current liabilities are a company’s short-term financial obligations that are due immediately or are payable within one year. Some examples of current liabilities are as follows:
- Accounts payable (A/P): Accounts payable are any obligations owed in the short term, including debts to creditors, vendors, and suppliers.
- Taxes: Taxes include sales taxes, income taxes, and payroll taxes.
- Payroll: Payroll includes any pay currently owed to employees, including salaries, wages, bonuses, and commissions.
- Loans: Examples of current loan liabilities are any short-term loans or current maturities of long-term debts.
What’s Excluded From Current Liabilities
Items that are excluded from current liabilities include any long-term financial obligations not payable within a year. Examples include the following:
- Permanent commercial loans
- Other long-term loans
- Long-term leases
- Bonds
Understanding the Current Ratio
Interpreting the current ratio allows businesses and investors to determine its current ability to cover its short-term financial obligations if it were to liquidate its current assets. By calculating the current ratio, it can help determine a company’s financial strength without the need to sell fixed assets or raise additional capital.
The higher the ratio, the more likely it is that a business will be able to meet its short-term obligations. That said, an evaluation of the current ratio is not entirely representative of a company’s financial health, and a good current ratio value can vary depending on the business industry. See the table below for a guide to understanding the current ratio.
Current Ratio | Current Assets vs Current Liabilities | Analysis |
|---|---|---|
1.0 | Current Assets are equal to Current Liabilities | Current assets are just enough to meet short-term obligations. |
Higher than 1.0 | Current Assets Are Greater Than Current Liabilities | The ideal situation because the company can meet short-term obligations with assets left over. |
Lower than 1.0 | Current Assets Are Less Than Current Liabilities | This situation is a problem because the company does not have enough current assets to meet short-term obligations. |
Generally, a ratio of 1.0 suggests that a business is capable of managing its funds with the ability to cover short-term expenses with its liquid assets, though likely without excess. A current ratio greater than 1.0 indicates that a business is solvent, has the resources to stay afloat in the event of a downturn, and attracts further investment or financing opportunities.
Typically, investors and other professionals consider a ratio of anywhere from 1.2 to 2.0 to be a sign of a healthy business, indicating a company with the ability to meet short-term liabilities while also investing a healthy percentage of its working capital. A current ratio greater than 2.0 may indicate that a company isn’t investing its short-term assets efficiently.
A current ratio below 1.0 means a business is at risk in the event of a downturn or default and would likely need to sell fixed assets, make new sales, or raise capital in some other way to meet current liabilities.
Why the Current Ratio Is Important
The importance of the current ratio is its ability to measure short-term financial health. By determining the value of both a company’s current assets and liabilities, stakeholders, creditors, and other investors can make calculations and gain insights as to how a company is managing its finances.
Additionally, a healthy current ratio can help a company attract better credit terms when it’s in need of financing. In addition to creditors, the current ratio offers insights to outside investors and company stakeholders regarding how capable a business is of covering current obligations while sustaining day-to-day operations.
Current Ratio Example
Current Assets | Current Liabilities | ||
|---|---|---|---|
Cash | $60,000 | Accounts Payable | $71,000 |
Cash Equivalents | $50,000 | Taxes | $35,000 |
Accounts Receivable | $30,000 | Payroll | $25,000 |
Inventory | $15,000 | Loans | $15,000 |
Other Current Assets | $5,000 | Other Current Liabilities | $5,000 |
Total Current Assets | $160,000 | Total Current Liabilities | $151,000 |
Current Ratio = $160,000 / $151,000 = 1.1 | |||
In the example above, the business has a current ratio of 1.1, which means it can meet its current obligations. That said, the ideal current ratio would be between 1.2 and 2.0, so there are steps the business could take to further improve its current ratio.
How to Improve the Current Ratio
To improve the current ratio, there are various strategies a company can partake in. Actionable steps may differ depending on the range of the ratio, whether it is higher or lower than 1.0, and can include the following:
- Selling long-term assets: A business that is below the targeted current ratio may consider certain long-term assets, such as underperforming properties or unused assets that still hold resale value. This will allow the company to increase cash on hand, which will improve the current ratio.
- Refinancing short-term debt: By refinancing short-term debt obligations (loans with a repayment term of less than one year) into long-term debt, a company can shift debt out of its current liabilities on its balance sheet. Businesses getting a small business loan may want to opt for long-term debt over short-term to keep the ratio in range. Be sure to understand a provider’s small business loan requirements before applying for financing.
- Reducing overhead expenses: A consistent review of a company’s short-term expenses allows businesses to find ways to improve their fiscal efficiency. These ways can include reducing travel expenditures, renegotiating vendor and supplier contracts, and managing department operating expenses.
Limitations of the Current Ratio
The current ratio can fluctuate at any given time, given the nature of ongoing payments to liabilities, assets being liquidated, and sales and other sources of revenue. For this reason, companies try to target a range rather than an exact ratio. And even then, the current ratio might not tell the whole story in regards to a company’s short-term financial health.
However, there are certain limitations involved when evaluating the current ratio. Such limitations can include the following:
- Difficulty comparing businesses in different industries: In some industries, extending short-term credit for more than 90 days may be common, while in others, it may be more critical to collect short-term liabilities quickly. So, short-term liabilities may differ slightly between companies in different industries.
- Assets may not be easily liquidated: Unlike the quick ratio, which we discuss more below, the current ratio includes assets that might not be easily liquidated, such as inventory. A company with a large portion of its assets tied up in inventory would be in worse shape than a company with a large amount of cash on hand. However, both could end up with the same current ratio.
- Large fluctuation for seasonal businesses: For businesses with seasonal sales, such as farmers, the ratio may be very high during those sales times and lower during quiet periods of the year. The current ratio of a seasonal company might not give you an accurate picture of a company’s short-term financial health.
Other Liquidity Ratios
Liquidity ratios are a variety of calculations that can be used to measure various aspects of a company’s financial position—mainly, its ability to cover short-term obligations with available assets. They are commonly used by parties who are evaluating the financial wellness of a business, whether it be to issue financing or make business decisions. Inclusive of the current ratio, other associated liquidity ratios consist of the quick ratio and the cash ratio.
The Quick Ratio
The quick ratio, or acid-test ratio, is similar to the current ratio and involves the same general calculation. The big difference between the two is that the quick ratio doesn’t include inventory in a company’s current assets. This is due to the belief that inventory can be difficult to sell off rapidly, and to do so may mean selling it at a loss.
The quick ratio is commonly used to measure the financial health of companies that count inventory as a large percentage of their current assets, such as retail and manufacturing businesses. A primary criticism of the quick ratio is that it may overestimate the difficulty of quickly selling inventory at market price.
The Cash Ratio
The cash ratio is a more conservative liquidity ratio. It is calculated in the same way as the current ratio and the quick ratio while excluding both inventory and A/R from current assets.
Like the quick ratio, the rationale behind this approach is that inventory and A/R may be difficult to convert to cash and thus may inflate a company’s perceived ability to meet short-term obligations. A criticism of the cash ratio is that it may be too conservative and underestimate a company’s ability to sell through inventory and to collect on its A/R.
Frequently Asked Questions (FAQs)
A good current ratio can vary depending on the industry your business resides in. Generally, a current ratio of 1.2 to 2.0 means your business is in a strong short-term financial position. If your current ratio is lower, you might be risking the ability to meet short-term liabilities. If your current ratio is higher than 2.0, you might not be properly investing your assets.
The current ratio measures a company’s ability to pay short-term obligations. A current ratio of 1.0 or higher means there are enough current assets to cover short-term liabilities. The current ratio is commonly used by creditors or investors to learn more about the financial position of a business.
If your current ratio drops below one, it means your company has insufficient current assets to meet short-term obligations. You will need to increase your current assets or reduce your current liabilities to raise your current ratio to at least 1.0 to be considered solvent.
Bottom Line
The current ratio is one of three commonly used liquidity ratios that company stakeholders, creditors, and investors use to measure short-term financial health. It is calculated by dividing a company’s current assets by its current liabilities. A current ratio below 1.0 indicates a business may be unable to cover its current liabilities with current assets. In general, a current ratio of 1.2 to 2.0 is considered healthy.
