What Is the Current Ratio?
The current ratio is a liquidity ratio that measures an organization's ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.
A current ratio that is in line with the industry average or slightly greater is generally considered sufficient. A current ratio that is lower than the industry average may indicate a higher risk of distress or bankruptcy.
Furthermore, if a company has a very high current ratio compared to their peer group, it indicates that management may not be using their assets efficiently.
The current ratio is called “current” because, unlike some other liquidity ratios, it includes all current assets and current liabilities.
Formula and Calculation for Current Ratio
To compute the ratio, analysts compare a company's current assets to its current liabilities. Current assets listed on an organization's balance sheet include cash, accounts receivable, inventory, and other current assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, short-term debts, and the current portion of long-term debt.
Explaining the Current Ratio.
The current ratio measures a company's ability to pay current, or short-term, liabilities (debts and payables) with its current, or short-term, assets (such as cash, inventory, and receivables).
An organization with a current ratio less than 1.0 does not, in many cases, have the capital on hand to meet its short-term obligations if they were all due at once, while a current ratio greater than one reflects the organization has the financial resources to remain solvent in the shorter-term.
Anyway, because the current ratio at any one time is just a snapshot, it is usually not a complete representation of an organization’s short-term liquidity or longer-term solvency.
For instance, an organization may have a very high current ratio, but its accounts receivable may be extremely aged, maybe because its customers pay very slowly, which may be hidden in the current ratio.
Analysts must also consider the quality of an organization’s other assets versus its obligations.
If the inventory is unable to be sold, the current ratio may still look reasonable at one point in time, but the company may be headed for default.
A current ratio of less than one may seem shocking, although different situations can affect the current ratio in a solid organization. For example, an ordinary monthly rotation for the organization’s collections and payment processes may lead to a high current ratio as payments are received, but a low current ratio as those collections wave.
Computing the current ratio at just one point in time could reflect the organization can’t cover all its current debts, but it doesn’t mean it won’t be able to once the payments are received.
Moreover, some organizations, especially larger retailers such as Walmart, have been able to negotiate much longer-than-average payment terms with their suppliers.
If a retailer doesn't offer credit to its customers, this can show on its balance sheet as a high payables balance comparable to its receivables balance.
Massive retailers can further minimize their inventory volume through an efficient supply chain, which makes their current assets decline against current liabilities, resulting in a lower current ratio.
The current ratio can be a helpful estimate of an organization’s short-term solvency when it is placed in the context of what has been historically normal for the company and its peer group.
It also offers more insight when computed frequently over many periods.
Analyzing the Current Ratio.
A ratio under 1.0 predicts that the organization’s debts due in a year or less are greater than its assets (cash or other short-term assets predicted to be converted to cash within a year or less).
On the other hand, As an assumption, the higher the current ratio, the more eligible an organization is for paying its debts because it has a larger proportion of short-term asset value relative to the value of its short-term liabilities.
But, while a high ratio, say over 3, could indicate the company can cover its current liabilities three times, it may indicate that it's not using its current assets efficiently, is not ensuring financing very well, or is not operating its working capital.
Current Ratio Changes Over Time.
What makes the current ratio “good” or “bad” frequently depends on how it is changing.
An organization that appears to have an adequate current ratio could be trending towards a situation where it will struggle to pay its bills.
Oppositely, an organization that may appear to be fighting now, could be making reasonable progress towards a healthier current ratio. In the first case, the trend of the current ratio over time would be predicted to damage the organization’s valuation.
How is the current ratio computed?
Computing the current ratio is very simple. To do so, simply divide the organization’s current assets by its current liabilities.
Current assets are those which can be converted into cash within one year, whereas current liabilities are debts expected to be paid within one year. Illustrations of current assets include cash, inventory, and accounts receivable.
Instances of current liabilities include accounts payable, wages payable, and the current portion of any scheduled interest or principal payments.
What does a current ratio of 1.5 mean?
A current ratio of 1.5 would reflect that the company has $1.50 of current assets for every $1.00 of current liabilities. For instance, suppose an organization’s current assets consist of $100,000 in cash plus $50,000 in accounts receivable. Its current liabilities, meanwhile, consist of $100,000 in accounts payable. In this scenario, the company would have a current ratio of 1.5, computed by dividing its current assets ($150,000) by its current liabilities ($100,000).
What is an acceptable current ratio?
What counts as a “good” current ratio will depend on the company’s industry and historical achievement.
As a general principle, however, a current ratio below 1.00 could indicate that a company might strive to meet its short-term duties, whereas ratios of 1.50 or greater would generally reflect sufficient liquidity.
Current Ratio vs. Other Liquidity Ratios.
Additional similar liquidity ratios can be used to strengthen a current ratio analysis. In each case, the differences in these measures can help an investor understand the current status of the company’s assets and liabilities from different positions, as well as to realize how those accounts are changing over time.
Typically used acid-test ratio (or quick ratio) compares an organization’s easily liquidated assets (including cash, accounts receivable, and short-term investments, excluding inventory and prepaid) to its current liabilities.
The cash asset ratio (or cash ratio) is also similar to the current ratio, but it compares only an organization’s cash and marketable securities cash to its current liabilities.
Finally, the operating cash flow ratio compares an organization’s active cash flow from operations (CFO) to its current liabilities.
Limits of Using the Current Ratio.
One limitation of using the current ratio emerges when using the ratio to compare different companies with one another.
Businesses vary substantially between industries, and so comparing the current ratios of organizations across several industries may not lead to financial knowledge.
For instance, in one enterprise it may be more typical to extend credit to customers for 90 days or longer, while in another enterprise, short-term collections are more crucial.
The industry that lengthens more credit may have a superficially powerful current ratio because their current assets would be higher.
It is usually more useful to compare organizations within the same industry.
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