The current ratio—sometimes called the working capital ratio—measures whether a company’s current assets are sufficient to cover its current liabilities. A higher number indicates better short-term financial health, and a ratio of 1-to-1 or better indicates a company has enough current assets to cover its short-term liabilities without selling fixed assets.
How the Current Ratio Works
The current ratio is an example of a liquidity ratio, like the quick ratio and cash ratio, used to compare a company’s current assets. Current assets are defined as assets convertible to cash within one year—with its current liabilities—liabilities that are due within one year. Measuring the current ratio allows businesses, as well as investors, to determine whether obligations can be met with current assets, and without selling fixed assets or raising capital.
The Current Ratio Formula
The current ratio formula divides the current assets of a company by its current liabilities. Current assets include liquid assets like cash as well as non-liquid assets like inventory, while current liabilities are short-term liabilities like payroll taxes and immediate payables like accrued compensation.
The current ratio formula is:
Current Ratio = Current Assets / Current Liabilities
Current Assets
Current assets are any balance sheet items, including liquid assets, that can be converted to cash within one year. Liquid assets include cash and cash equivalents as well as accounts receivable and marketable securities because they are generally assumed to be convertible to cash within one year.
Some examples of current assets are:
- Cash: Cash includes any funds held in checking or savings accounts, any coins or currency (such as 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 (AR): AR include 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 finished products as well as raw materials that will be used in the manufacture of a company’s products.
What’s Not Included in Current Assets
Assets that are not considered current assets are those that cannot be converted to cash within one year. These assets are called fixed assets, and include any assets that are not sold or otherwise consumed by a business during normal operations, such as plant, property, and equipment.
Some examples of assets not included in current assets are:
- Property: Property includes any buildings, land, or other real property 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. These include liabilities such as accounts payable, income and payroll taxes, short-term loans, and current maturities of long-term debt.
Some examples of current liabilities are:
- Accounts payable (AP): 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 Not Included in Current Liabilities
Not included in current liabilities are any long-term financial obligations not payable within a year. These include permanent commercial loans, which are any mortgages on recently built commercial properties, other long-term loans, long-term leases, bonds, and debentures.
How to Interpret Current Ratio Results
Interpreting a business’ current ratio is fairly straightforward. The higher the ratio, the more likely it is that a business will be able to meet its short-term obligations. Any ratio greater than 1-to-1 indicates a business can at least meet current liabilities with current assets. Conversely, a ratio less than 1-to-1 indicates that a business cannot meet current short-term obligations without selling fixed assets, making new sales, or raising capital in some other way.
What Is a Good Current Ratio?
A good current ratio is somewhat difficult to peg, and may vary depending on the industry. As its name suggests, the current ratio of any one company is constantly changing; this is due to 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-to-1 and 2-to-1 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-to-1 may indicate that a company is not investing short-term assets efficiently.
Apple Current Ratio Example
Current Assets | (In Millions) |
|---|---|
Cash and cash equivalents | $ 48,844.00 |
Marketable securities | $ 51,713.00 |
Accounts receivable, net | $ 22,926.00 |
Inventories | $ 4,106.00 |
Vendor non-trade receivables | $ 22,878.00 |
Other current assets | $ 12,352.00 |
Total current assets | $ 162,819.00 |
Current Liabilities | |
Accounts payable | $ 46,236.00 |
Other current liabilities | $ 37,720.00 |
Deferred revenue | $ 5,522.00 |
Commercial paper | $ 5,980.00 |
Term debt | $ 10,260.00 |
Total current liabilities | $ 105,718.00 |
Current ratio: | 1.54 |
Source: Apple 10-K 2019, 9.28.2019
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 by providing immediate insight into a business’ short-term financial health. It also gives a company and its investors advance awareness that current assets are not sufficient to cover current liabilities.
Additionally, a healthy current ratio can help a company attract better credit terms when it is 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.
Examples of 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’ financial health, they can be used by investors as well as creditors when determining whether to offer financing. The three common liquidity ratios are the current ratio, the quick ratio, and the cash ratio.
The Current Ratio vs the Quick Ratio
The quick ratio, or acid-test ratio, is very similar to the current ratio and involves the same general calculation. The primary difference between the two is the quick ratio does not include inventory in a company’s current assets.
The rationale is that inventory can be difficult to sell off rapidly, and to do so may mean selling it at a loss. It 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 Current Ratio vs the Cash Ratio
The cash ratio is the most conservative liquidity ratio, and is calculated in the same way as the current ratio and the quick ratio while excluding both inventory and accounts receivable from current assets.
Like the quick ratio, the rationale behind this conservative approach is that inventory and accounts receivable 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, underestimating a company’s ability to sell through inventory as well as collect on its accounts receivable.
Pros & Cons of Using the Current Ratio
Calculating the current ratio is an effective tool useful for understanding a company’s short-term financial health by measuring its ability to cover current liabilities with current assets. However, it is only one tool among many and, while it is a simple and effective model for many businesses, it may fall short of accurately measuring the financial health of companies with certain types of assets or in certain industries.
Pros of the Current Ratio
Some of the advantages of the current ratio are:
- Simple measurement of financial health: A primary advantage of the current ratio is the simplicity of the calculation, meaning it can be run as often as needed to measure a company’s immediate financial health.
- Helps measure efficiency converting assets to cash: By measuring current ratio and tracking it over time, a company can track its efficiency converting its assets to cash and forecast future performance.
- Indicates when a company should invest current assets vs retain: Tracking the current ratio often allows a company to determine when it should invest current assets or retain them in order to keep the ratio in the desired range.
- Demonstrates a company’s ability to meet debt obligations: The current ratio gives creditors a simple measurement to assist in evaluating whether to grant credit or debt to a company based on its ability to meet current liabilities.
Cons of the Current Ratio
Some of the disadvantages of the current ratio are:
- Misleading results for inventory-heavy current assets: By including inventory, it may overestimate the ability of a company to liquidate assets at market price.
- May overestimate the ability to collect on accounts receivable (AR): The current ratio does not take into account the length of time necessary to collect AR, nor does it accurately identify AR at risk of default.
- Misleading results for businesses with seasonal fluctuations: Businesses with seasonal sales changes may have a very high current ratio during some months and a very low current ratio during others.
- Not a reliable indicator of asset quality: Some assets may be difficult to liquidate (for example, inventory that is outdated) at market price, and may need to be sold at a loss.
- Easily manipulated: Like most ratios, the current ratio can be easily manipulated. Inventory that is overvalued, for example, can inflate the current ratio, which can be used to borrow money the business may have difficulty repaying.
How to Improve the Current Ratio
There are several steps that 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. Among these strategies, businesses can increase accounts receivables collections, liquidate fixed assets, reduce costs, manage accounts payable, and invest assets.
Some of the most common ways to improve the current ratio are:
1. Sell Long-term Assets
Many businesses hold long-term assets, such as commercial property and buildings, as well as manufacturing equipment. A business that is below the targeted current ratio may consider selling unneeded 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.
2. Refinance Short-term Debt
By refinancing short-term debt obligations (for example, term loans with a six- to 12-month repayment term) 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 debt in order to keep the ratio in range.
3. Reduce Overhead Expenses
Monitoring and regularly reviewing a company’s short-term fixed and variable expenses allows businesses to employ active strategies to minimize these expenses through refined processes and efficient budget management. Examples include reducing travel expenditures, renegotiating vendor and supplier contracts, and managing department operating expenses (OPEX). The result increases cash on hand in the business’ checking account, considered a current asset.
Bottom Line
The current ratio is one of three common liquidity ratios used by company stakeholders, as well as creditors and investors, to measure short-term financial health. A current ratio below 1-to-1 indicates a business may not be able to cover its current liabilities with current assets. A current ratio above 2-to-1 may indicate a company is not making efficient use of its short-term assets. In general, a current ratio between 1.2-to-1 and 2-to-1 is considered healthy.
