The current ratio, also known as the working capital ratio, is a liquidity ratio that measures the proportion of a company’s current assets to its current liabilities. It is used to measure a company’s short-term financial health. The current ratio indicates whether or not a company has enough short-term assets to cover its short-term financial obligations.
The current ratio is calculated to measure the company’s liquidity and whether its current assets are sufficient to pay its current liabilities. This helps a company to run its day-to-day business operations. Net working capital is what’s left of the company’s assets after deducting its liabilities.
The Current Ratio Formula
To get the current ratio, the current assets of a company is divided by its current liabilities. Current assets include non-liquid assets like inventory, while current liabilities are short-term liabilities and immediate payables.
The formula for calculating the current ratio is as follows:
Current Ratio = (Current Assets) / (Current Liabilities)
Current assets are balance sheet asset accounts that are considered liquid, meaning that they can be converted to cash within one year. The items that are considered current assets include cash, cash equivalents, marketable securities, prepaid expenses, accounts receivable, and inventory. Long-term assets, such as equipment and real estate, are not included.
Current liabilities represent a company’s financial obligations that are payable within one year. Examples of current liabilities include accounts payable, sales taxes, income taxes, payroll taxes, short-term loans, current maturities of long-term loans, accrued expenses, dividends declared, and more. They don’t include long-term liabilities such as a permanent commercial mortgage or something similar.
The best current ratio is between 1.2 to 2. A current ratio below 1 means that the company doesn’t have enough liquid assets to cover its short-term liabilities. A ratio equal to 1 indicates that current assets are equal to current liabilities and that a company is just able to cover all of its short-term obligations.
However, while it may seem that the higher the current ratio the better, a ratio higher than 2 may indicate that the company is not investing its short-term assets efficiently. This is why the best current ratio is between 1.2 – 2. It gives a company enough of a buffer to cover all of its short-term liabilities but also ensures that its investing idle working capital.
Why The Current Ratio Is Important
The current ratio is important because it provides an overview of the business’s short-term financial health. It gives early warning signs to the company if a business is not working efficiently. It also tells the company if its current assets are not sufficient enough to cover its current liabilities.
It can also help the company attract better credit terms when they need financing. Creditors, investors, capitalists, and stakeholders will take a look at the company’s current ratio to determine how able the business is to cover its current obligations while sustaining its day-to-day operations.
The current ratio is similar to the quick ratio in the sense that they measure a company’s short-term financial health. However, the quick ratio does not include inventory in its current assets, while inventory forms part of the current ratio.
Pros and Cons of Using the Current Ratio
Keeping track of the current ratio is essential for the financial health and growth of a business. However, using this tool as a means of assessing the liquidity of a company has its advantages and disadvantages.
Pros of the Current Ratio
- Business owners can get a better overview of their short-term financial health.
- Companies will know if they should invest their current assets or keep them idle.
- Businesses will know if they have too much inventory in their current assets, indicating that the inventory turnover is low.
Cons of the Current Ratio
- If inventories make up a large portion of the company’s current assets, it can cause a misleading result of the current ratio because inventories cannot be immediately sold.
- Long accounts receivables terms can cause an inaccurate liquidity measurement.
- Companies that are drawing cash from a line of credit may have an abnormally low current ratio.
How to Improve the Current Ratio
Companies with a current ratio of 1 or lower might be an indication that they are not financially healthy. The good news is there are strategies that businesses may use in order to improve a low current ratio. These strategies include accounts payable repayment, accounts receivable management, and cost reduction.
Below are the top 3 ways to improve a company’s current ratio:
1. Sell Long-Term Assets
It’s not uncommon for companies to have long-term assets with useful lives greater than 1 year. For some of these businesses, their long-term assets like capital equipment might be unproductive but still hold resale value. If a company sells some of its unused long-term assets for cash you can increase your current assets and therefore your current ratio.
2. Refinance Short-Term Debt
Short-term debt is considered a current liability. The more of it you have on your balance sheet the lower your current ratio. When increasing your liquidity measures like the working capital ratio, you can refinance your short-term obligations with long-term debt, a long-term obligation that isn’t included in the measurement. This will increase your current ratio.
Further, if you’re considering taking on additional debt and want to keep your current ratio high you can opt for long-term debt from the onset. However, some companies need short-term working capital loans or can’t qualify for longer-term options, limiting their choices.
3. Reduce Overhead Expenses
The company’s short-term fixed and variable expenses should be regularly reviewed and monitored. Companies can try to find ways to reduce these expenses by refining their processes, tightening their budgets, and going with lower-cost options, if available. The result is that a company can save more cash in its business checking account, a current asset.
The current ratio is one of the liquidity measures that companies use to determine their short-term financial health. A current ratio below 1 is an indicator that the business may not be doing well and that its current liabilities exceed its current assets. On the other hand, a current ratio above 2 means that the company isn’t using its short-term assets efficiently.