This article is part of a larger series on Business Financing.
The current ratio, also known as the working capital ratio, measures if a company’s current assets are sufficient to cover its current liabilities. The current ratio divides a company’s current assets by its current liabilities. Current assets are defined as cash and other equivalents that can be converted to cash within one year. Current liabilities are short-term obligations, such as payroll, accounts payable (A/P), and other debts, which are due within one 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. Measuring the current ratio will allow businesses and investors to determine whether obligations can be met with current assets without requiring a business to sell fixed assets or raise additional capital.
How to Calculate the Current Ratio
The current ratio formula is:
Current Ratio = Current Assets / Current Liabilities
Current assets are any balance sheet items, including liquid assets, which can be converted to cash within one year. Some examples of current assets are:
- 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, which will be used in the manufacture of a company’s products.
What’s Not Included in Current Assets
Assets that aren’t considered current assets are those that cannot be converted to cash within one year. These are often referred to as fixed assets. Some examples include:
- 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 are a company’s short-term financial obligations that are due immediately or are payable within one year. Some examples of current liabilities are:
- A/P: A/P 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 Not Included in Current Liabilities
Items that aren’t included in current liabilities include any long-term financial obligations not payable within a year. Examples include permanent commercial loans, other long-term loans, long-term leases, and bonds.
What Is a Good Current Ratio?
Interpreting a business’s current ratio is fairly straightforward. The higher the ratio, the more likely it’s that a business will be able to meet its short-term obligations. A ratio that is greater than a 1.0 indicates a business can at least meet current liabilities with current assets. A ratio below 1.0 means a business would need to sell fixed assets, make new sales, or raise capital in some other way to meet current liabilities.
While a ratio of 1.0 is indicative of a business being able to hold its own and pay the bills, it may not be indicative of business health. A good current ratio can vary depending on the industry. As its name suggests, the current ratio of any one company is constantly changing. This is because 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.
Generally, investors and other professionals consider a ratio between 1.2 and 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.
Why the Current Ratio Is Important
The current ratio is a useful tool for businesses and investors that offers early warning signs that a business may not be using its working capital efficiently. It does this by providing immediate insight into a business’s short-term financial health. It also gives a company and its investors advance awareness that current assets are insufficient to cover current liabilities.
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.
Apple Current Ratio Example
Cash & Cash Equivalents
Vendor Nontrade Receivables
Other Current Assets
Total Current Assets
Other Current Liabilities
Total Current Liabilities
Source: Apple 10-K 2021, October 2021
Using Apple’s 10-K report as an example, its current ratio shows a business that’s able to support its current obligations; however, its ratio has dropped from 1.54 in 2019 to 1.36 in 2020 to 1.07 as of October 2021. A deeper glance into its balance sheet showed Apple moved a portion of its marketable securities into non-current asset status during 2021. Apple also had increased its A/P by almost 30% from the prior year due to orders for phones and computers increasing due to increased consumer demand.
While the current ratio is useful as a single snapshot of business working capital, the overall health and performance of a business is still a greater consideration for investors and lenders.
How to Improve the Current Ratio
There are several steps a company can take to improve the current ratio. The proper strategy may differ depending on whether the current ratio is below or exceeding its targeted range. Some of the most common ways to improve the current ratio are:
- Sell long-term assets: A business that’s 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.
- Refinance short-term debt: By refinancing short-term debt obligations, such as loans with a repayment term of less than one year, into long-term debt, a company can shift some of the corresponding liability out of its current liabilities on its balance sheet. Businesses taking on additional debt may want to opt for long-term debt over short-term to keep the ratio in range.
- Reduce overhead expenses: 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.
Other Liquidity Ratios
Liquidity ratios are calculations that can be employed to examine a company’s ability to cover its short-term obligations. In addition to their use by company stakeholders to measure the business’s financial health, they can be used by investors, as well as creditors, when determining whether to offer financing. Beyond the current ratio, the quick ratio and cash ratio are also used.
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 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 current assets, such as retail and manufacturing businesses. A primary criticism of the quick ratio is it may overestimate the difficulty of quickly selling inventory at market price.
The Cash Ratio
The cash ratio is a more conservative liquidity ratio and 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 conservative 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.
The current ratio is one of three commonly used liquidity ratios that company stakeholders, creditors, and investors use to measure short-term financial health. A current ratio below 1.0 indicates a business may not be able to cover its current liabilities with current assets. In general, a current ratio between 1.2 to 2.0 is considered healthy.