What’s it: The current ratio is a financial ratio to measure liquidity by considering all short-term assets and liabilities. It is the loosest ratio among other liquidity ratios such as quick and cash ratios.
We get the current ratio is by dividing current assets by current liabilities. A higher number is preferable because the company has the resources to meet short-term obligations.
However, we must also be careful in drawing conclusions because it includes some less liquid accounts in the calculation, such as inventories. For this reason, ratios might give misleading conclusions about the actual condition of liquidity.
Why is the current ratio important?
Liquidity is important because it impacts how healthy a company’s finances are. It is measured using several ratios, including current ratio, quick ratio, and cash ratio.
The current ratio compares the company’s current assets with current liabilities. It tells us how much current assets are available to cover all liabilities due in one year. It takes into account not only cash and cash equivalents but also other less liquid assets such as inventories.
The company’s current assets should be greater than its current liabilities. If not, it indicates the company is experiencing liquidity problems. As a result, it may have to take on debt or sell its long-term assets to pay off its maturing obligations.
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How to calculate the current ratio?
Calculating the current ratio requires two inputs: current assets and current liabilities. We can find both on the balance sheet.
Current assets usually contain accounts such as cash and cash equivalents, short-term investments (marketable securities), accounts receivable, and inventories. Not all of these accounts are liquid and can be used immediately. Meanwhile, other accounts also do not contribute to cash inflows – only represent inflows of economic benefits such as prepaid expenses.
Meanwhile, current liabilities represent obligations expected to be settled by the company in the next twelve months. It includes accounts such as accounts payable and wages payable.
After getting these two numbers, we divide current assets by current liabilities to get the ratio. Here is the current ratio formula:
- Current ratio = Current assets / Current liabilities
For example, a company reports current assets of $1.5 million, consisting of cash and cash equivalents of $400,000, accounts receivable of $100,000, and inventory of $1,000,000. Meanwhile, the company reported current liabilities of $1.0 million in liabilities.
In that case, the company has a current ratio of 1.5 = $1.5 million / $1.0 million.
How to interpret the current ratio?
A higher ratio is desirable because it indicates a higher level of liquidity. The company has sufficient resources to cover its short-term bills.
Conversely, a low ratio indicates tight liquidity. If current assets are insufficient, the company is in financial trouble. As a result, it may have to be forced to sell some of its long-term assets, such as vehicles, to settle bills. Or, the company must take on debt, which increases the burden in the future.
Then, we should compare the high and low ratios with the industry average. Again, if it’s at least a little higher than average, it’s acceptable. But, if it’s slightly lower, it could indicate a liquidity problem, and the company is struggling to pay its bills.
The current ratio includes less liquid accounts or does not contribute to cash inflows. And in some companies, including them in the calculation can be misleading because it doesn’t reflect the actual state of liquidity. But, in other companies, it may not be a material problem.
Take, for example, retail and heavy equipment companies. Heavy equipment companies need a longer time to sell the goods in the warehouse because there is relatively little demand. On the other hand, retailers have high inventory turnover and can collect cash immediately. Thus, taking inventory into account can be misleading if we examine heavy equipment companies rather than retail companies.
To overcome this and give a better picture of the company’s liquidity condition, we can examine other ratios such as the quick and cash ratios. Both exclude the above accounts and are more conservative in defining liquidity.
What is the ideal current ratio?
A current ratio of 1 is usually the limit. It shows the company’s current assets are equal to the book value of its current liabilities. If it is lower, it could signal a liquidity problem.
What is the ideal number? It can vary between industries. For example, in some industries, a ratio of 1.50 to 3.00 generally indicates sufficient liquidity. But not in other industries. In addition, some investors and creditors may prefer slightly higher numbers because the company is considered more financially stable.
What to read next
- Liquidity Ratio: Examples, Formulas, How to Calculate
- Current Ratio: How to Calculate and Interpret
- Quick Ratio: Formula, Calculation, Interpretation
- Cash Ratio: Formula, Calculation, and Interpretation
- Defensive Interval Ratio: Importance, Calculation, and Interpretation
- Acid Test Ratio: Meaning, Formula, Calculation
- Cash Conversion Cycle: How it Works, Calculation and Interpretation