Current Ratio Explained: a Vital Liquidity Metric
The current ratio of 1.0x is right on the cusp of an acceptable value, since if the ratio dips below 1.0x, that means the company’s current assets cannot cover its current liabilities. Investors can use this type of liquidity ratio to make comparisons with a company’s peers and competitors. Ultimately, the current ratio helps investors understand a company’s ability to cover its short-term debts with its current assets. Current assets listed on a company’s balance sheet include cash, accounts receivable, inventory, and other current assets (OCA) that are expected to be liquidated or turned into cash in less than one year.
Bankrate logo
In this scenario, the company would have a current ratio of 1.5, calculated by dividing its current assets ($150,000) by its current liabilities ($100,000). Working Capital is the difference between current assets and current liabilities. A business’ liquidity is determined by the level of cash, marketable securities, Accounts Receivable, and other liquid assets that are easily converted into cash. The more liquid a company’s balance sheet is, the greater its Working Capital (and therefore its ability to maneuver in times of crisis). Other measures of liquidity and solvency that are similar to the current ratio might be more useful, depending on the situation.
Current assets (also called short-term assets) are cash or any other asset that will be converted to cash within one year. You can find them on the balance sheet, alongside all of your business’s other assets. A very high current ratio could mean that a company has substantial assets to cover its liabilities. However, it could also mean that a business is not using its resources effectively.
To calculate the current ratio, divide the company’s current assets by its current liabilities. Current assets are those that can be converted into cash within one year, while current liabilities are obligations expected to be paid within one year. Examples of current assets include cash, inventory, and accounts receivable. Examples of current liabilities include accounts payable, wages payable, 5 missteps to avoid when evaluating internal controls and the current portion of any scheduled interest or principal payments. Both current assets and current liabilities are listed on a company’s balance sheet.
Table of Contents
The current ratio relates the current assets of the business to its current liabilities. The current ratio or working capital ratio is a ratio of current assets to current liabilities within a business. To see how current ratio can change over time, and why a temporarily lower current ratio might not bother investors or analysts, let’s look at the balance sheet for Apple Inc. This could indicate that the company has better collections, faster inventory turnover, or simply a better ability to pay down its debt. The trend is also more stable, with all the values being relatively close together and no sudden jumps or increases from year to year.
Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs. Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos.
These typically have a maturity period of one year or less, are bought and sold on a public stock exchange, and can usually be sold within three months on the market. The increase in inventory could stem from reduced customer demand, which directly causes the inventory on hand to increase — which can be good for raising debt financing (i.e. more collateral), but a potential red flag. Current assets refers to the sum of all assets that will be used or turned to cash in the next year. So, a ratio of 2.65 means that Sample Limited has more than enough cash to meet its immediate obligations. Hence, Company Y’s ability to meet its current obligations can in no way be considered worse than X’s.
Reviewed by Subject Matter Experts
Though they may appear to have the same level of risk, analysts would have different expectations for each company depending on how the current ratio of each had changed over time. In the first case, the trend of the current ratio over time would be expected to harm the company’s valuation. Meanwhile, an improving current ratio could indicate an opportunity to invest in an undervalued stock amid a turnaround. Public companies don’t report their current ratio, though all the information needed to calculate frisco bookkeeping and tax services the ratio is contained in the company’s financial statements.
Company B has more cash, which is the most liquid asset, and more accounts receivable, which could be collected more quickly than liquidating inventory. Although the total value of current assets matches, Company B is in a more liquid, solvent position. To calculate the ratio, analysts compare a company’s current assets to its current liabilities. A ratio under 1.00 indicates that the company’s debts due in a year or less are greater than its cash or other short-term assets expected to be converted to cash within a year or less.
Current ratios over 1.00 indicate that a company’s current assets are greater than its current liabilities, meaning it could more easily pay of short-term debts. A current ratio of 1.50 or greater would generally indicate ample liquidity. As another example, large retailers often negotiate much longer-than-average payment terms with their suppliers.
The current liabilities of Company A and Company B are also very different. Company A has more accounts payable, while Company B has a greater amount in short-term notes payable. This would be worth more investigation because it is likely that the accounts payable will have to be paid before the entire balance of the notes-payable account.
- The limitations of the current ratio – which must be understood to properly use the financial metric – are as follows.
- If all current liabilities of Apple had been immediately due at the end of 2021, the company could have paid all of its bills without leveraging long-term assets.
- We follow strict ethical journalism practices, which includes presenting unbiased information and citing reliable, attributed resources.
- The current ratio also sheds light on the overall debt burden of the company.
- It’s the most conservative measure of liquidity and, therefore, the most reliable, industry-neutral method of calculating it.
The current ratio reflects a company’s capacity to pay off all its short-term obligations, under the hypothetical scenario that short-term obligations are due right now. Like most performance measures, it should be taken along with other factors for well-contextualized decision-making. Current liabilities include accounts payable, wages, accrued expenses, accrued interest and short-term debt.
A current ratio above 1 signifies that a company has more assets than liabilities. The current ratio may not be particularly helpful in evaluating companies across different industries, but it might be a more effective tool in analyzing businesses within the same industry. The current ratio, in particular, is one way to evaluate a company’s liquidity, specifically the ease with which they can cover their short-term obligations. However, it is not the only ratio an interested party can use to evaluate corporate liquidity. The current ratio is one tool you can use to analyze a company and its financial state.
The role of the current ratio in financial analysis
Apple technically did not have enough current assets on hand to pay all of its short-term bills. These calculations are fairly advanced, and you probably won’t need to perform them for your business, but if you’re curious, you can read more about the current cash debt coverage ratio and the CCC. The quick ratio (also sometimes called the acid-test ratio) is a more conservative version of the current ratio. These are future expenses that have been paid in advance that haven’t yet been used up or expired. Generally, prepaid expenses that will be used up within one year are initially reported on the balance sheet as a current asset.
Because inventory levels vary widely across industries, in theory, this ratio should give us a better reading of a company’s liquidity than the current ratio. Here, we’ll go over how to calculate the current ratio and how it compares to some other financial ratios. Your ability to pay them is called “liquidity,” and liquidity is one of the first things that accountants and investors will look at when assessing the health of your business. Businesses may experience fluctuations in their current ratio as a result of seasonal changes. For example, a retail business may have a higher level of inventory during the holiday season, which could impact its ratio of assets to liabilities. Further, a company may need to borrow more during slow seasons to fund its operations, which could also impact the current ratio.