What is the Current Ratio?

The current ratio is like a business’ credit score...

Just as your credit score is an indicator of your ability to pay off personal debts, a current ratio is a single number that quickly gives a sense of a company’s ability to meet its obligations.

A current ratio is one of three liquidity ratios that investors and creditors use to measure how liquid a company is (the other two are the quick ratio and cash ratio). Liquidity ratios indicate how capable businesses are of paying off their short-term debts.

Investors can use this number as part of their analysis of how stable and profitable a company is — While creditors use it to determine whether they think a company is capable of taking on (and paying off) more debt.

The current ratio helps us measure the short-term financial strength of a company –- The higher the number, the more stable the company is; the lower the number, the higher the risk of liquidity problems.

A working capital ratio less than 1 shows that a company’s debt due in the next 12 months is more than the value of its existing short-term assets (cash and assets that have the potential to be liquidated during that time frame.)

In other words, a company with a current ratio of less than 1 will need to either sell off or cash in some of its long-term assets or find another way to raise cash (such as selling equity or borrowing yet more money) to keep up with its bills.

Alternatively, if a company has a current ratio higher than 1, it shows they have more than enough assets to cover their short-term obligations. However, if the ratio is too high, it may mean the business is not properly managing its assets. Typically a company with a ratio of 3 or more is considered to be overseeing its assets improperly. For instance, instead of having so much cash on hand, it could be invested back into the company in the form of long-term assets (such as property, plants, or equipment) or distributed to shareholders in the form of dividends.

The current ratio calculation is current assets divided by current liabilities (debt). This calculation shows the inverse relationship between a company’s present debt level and its ratio. In other words, as a company takes on more short-term debt, it’s ratio will decrease. And as it pays off more of its short-term debt, it’s ratio will increase. (Assuming, of course, that the level of current assets remains the same.)

Some examples of current debt are employee payroll, vendor credit, interest payable on long-term debt, and trades payable.

If the working capital ratio of a company is less than one, it may have difficulty paying these obligations. This problem could translate to employees and vendors not being paid on time, missing interest payments, etc. And if payment is late, it could lead to an increased debt due to late fees and penalties. It could also negatively impact the business in other ways. For instance, if a company always pays a vendor late, the vendor may refuse to extend credit anymore and demand cash before providing services, or refuse to be a supplier for the business any longer.

There are three primary liquidity ratios:

1. The current ratio (working capital ratio)
2. The quick ratio
3. The cash ratio

All three ratios help measure how liquid a company is (how capable it is of meeting its short term debt using its current assets). However, each calculation is slightly different.

The working capital ratio is determined by dividing current assets by the current liabilities.

The quick ratio, or acid-test ratio, is current assets-inventory divided by current liabilities. This ratio provides a more conservative number and factors in the reality that inventory is not as liquid or readily convertible to cash as other current assets are.

The cash ratio is cash and cash equivalents/current liabilities. This ratio is the most conservative of the three. It measures how capable a company is of paying off its current debts only using cash or a cash equivalent, like a certificate of deposit or a treasury bill.

The current ratio can provide a useful snapshot of a company’s liquidity. But this one number is not the whole picture. If you want to see the entire picture of a company’s financial health, it’s essential to look at more than just current assets and liabilities.

For instance, WalMart had a current ratio below one at the end of its Fiscal 2018 — That doesn’t mean the company isn’t profitable or is at risk of going out of business. Source: Walmart 2018 Annual Report

Alternatively, in some cases, a company may have a ratio above one and still struggle to pay off all its short-term debts on time. For instance, imagine a company that has $2M in accounts receivable (a current asset account) and $1M in accounts payable (a current liability account). If the company had no other existing assets or liabilities, its current ratio would be 2.

But what if all the accounts payable need to be paid in 30 days, and all of the accounts receivable money isn’t expected to be collected (or turned into cash) for at least 60 days? In this case, even with a ‘healthy’ current ratio, the fictional company is going to be over a month late paying all its debts. Current ratios don’t take into account the timing of when debts need to be paid or when non-cash assets will be turned into cash.

Another limitation of the current ratio is that it’s not great for comparing companies across industries. For instance, an industry where businesses tend to carry a lot of inventory will typically result in higher current ratios. But this doesn’t necessarily mean they’re more capable of paying off their short-term debts — Especially if they turn over inventory slowly.

The current ratio is commonly reported as a single number, such as 2. However, it is also considered proper to document this number as a ratio, such as 2:1, because the ratio is a comparison of current assets to current liabilities. So a ratio of 2.1 means that a company has twice as much in current assets as current debt.

A ratio of 1:1 means the total current assets are equivalent to the total current debt. This number indicates that a company has just enough in current assets to cover all its current liabilities, but has no extra buffer.

Any ratio below 1, such as 0.5:1, indicates the company doesn’t have enough in current assets to cover all of its current liabilities. In this example, the company would only be able to cover half of its current outstanding debt using its current assets.