Current Ratio Formula
May 9, 2025
What is the Current Ratio?
The Current Ratio is a liquidity ratio that measures a company’s ability to pay off its short-term obligations with its current assets. It is calculated by dividing current assets by current liabilities. The Current Ratio provides a quick snapshot of a company’s financial health. A ratio above one indicates that the company has more current assets than current liabilities, which is a sign of financial stability.
Key Learning Points
- The Current Ratio is a liquidity ratio that measures a company’s ability to pay off its short-term obligations with its current assets
- It is calculated by dividing current assets by current liabilities
- A desirable Current Ratio is above 1: this indicates that the company has more current assets than current liabilities, which is a sign of financial health
- Companies often compare their Current Ratio with industry standards to gauge their performance: a higher ratio may indicate better liquidity compared to competitors, while a lower ratio may signal potential liquidity issues
How Current Ratio Works
The Current Ratio tests a company’s ability to pay its short-term obligations. Essentially, it answers the question: “Can my current assets pay off my current liabilities?” A desirable Current Ratio is above 1, and ideally far above 1. This indicates that the company has more current assets than current liabilities, which is a sign of financial health.
How Is the Current Ratio Calculated?
The Current Ratio is calculated by dividing a company’s current assets by its current liabilities.
Current Ratio Formula
The formula for calculating the Current Ratio is:
Example of the Current Ratio Formula
Let’s say a company has $500,000 in current assets and $250,000 in current liabilities. The Current Ratio would be calculated as follows:
This means the company has twice as many current assets as current liabilities, indicating a strong ability to pay off its short-term obligations.
Current Ratio Formula – What are Current Assets?
An asset is a resource owned or controlled by a business, expected to generate future economic benefits. Businesses classify assets on the balance sheet as current or non-current. Current assets are resources controlled by an entity that are expected to be converted into cash, consumed through the business or discharged in less than 12 months.
Current Ratio Formula – What are Current Liabilities?
A liability is a financial obligation that takes priority over shareholders’ claims and likely requires future cash outflow. Companies classify liabilities on the balance sheet as current or non-current. A current liability represents a short-term financial obligation and is payable within 12 months.
Why Use the Current Ratio Formula?
The Current Ratio formula is used to assess a company’s ability to pay off its short-term obligations with its current assets. Here are some reasons why it is important:
Financial Health Indicator
The Current Ratio provides a quick snapshot of a company’s financial health. A ratio above one indicates that the company has more current assets than current liabilities, which is a sign of financial stability. It helps investors, creditors, and management understand whether the company can meet its short-term obligations
Liquidity Measurement
The Current Ratio measures liquidity, which is the ability to convert assets into cash to pay off liabilities. It includes all current assets, such as cash, inventory, and accounts receivable, giving a comprehensive view of the company’s liquidity position.
Comparison with Industry Standards
Companies often compare their Current Ratio with industry standards to gauge their performance. A higher ratio may indicate better liquidity compared to competitors, while a lower ratio may signal potential liquidity issues.
Decision-Making Tool
Management use the Current Ratio to help make better informed decisions about working capital management. It helps in planning for future expenses, investments, and managing cash flow effectively.
Risk Assessment
Creditors and investors use the Current Ratio to assess the risk associated with lending to or investing in a company. A higher ratio reduces the risk of default, making the company more attractive to lenders and investors.
Current Ratio vs. Other Liquidity Ratios
The Current Ratio is one of several liquidity ratios used to measure a company’s ability to pay off its short-term obligations.
Current Ratio
The Current Ratio is calculated by dividing current assets by current liabilities. It tests a company’s ability to pay its short-term obligations. A desirable Current Ratio is above 1, and ideally far above 1.
OWC to Sales Ratio
The OWC (Operating Working Capital) to Sales Ratio is calculated by dividing OWC by the sales figure. It looks at the ratio of short-term assets required to operate a business or cash tied up in operations compared to sales. Ideally, this ratio should stay constant or decline slightly as sales grow.
Cash Ratio
The Cash Ratio is calculated by dividing cash by current liabilities. It tests a company’s ability to repay short-term obligations using just cash which is a component of current assets. A desirable Cash Ratio is higher than one to ensure suppliers feel confident that they can be paid at any time.
Comparison between Current Ratio, Cash Ratio and OWC/Sales Ratio
The Current Ratio includes all current assets, such as inventory and accounts receivable, while the Cash Ratio only includes cash. Thus, the cash ratio can be a more immediate or liquid ratio measurement
The OWC to Sales Ratio focuses on the relationship between operating working capital and sales, providing insight into how efficiently a company is using its short-term assets to generate sales.
Each ratio provides a different perspective on a company’s liquidity and financial health. The Current Ratio gives a broad view, the Cash Ratio offers a more conservative measure, and the OWC to Sales Ratio provides insight into operational efficiency.
Limitations of Using the Current Ratio
While the Current Ratio is a useful measure of a company’s liquidity, it has some limitations:
- The ratio includes ALL current assets, but not all current assets are equally liquid
- For example, inventory may not be as easily converted to cash as accounts receivable
- The ratio doesn’t consider the timing of cash inflows and outflows – a company might have a high Current Ratio but still face liquidity issues if its cash inflows are delayed
- A very high Current Ratio might indicate that a company is not using its assets efficiently; conversely, a low ratio might not necessarily mean poor liquidity if the company has fast-moving inventory or quick receivables
What Is a Good Current Ratio?
A good Current Ratio is generally considered to be above one, indicating that the company has more current assets than current liabilities. Analysts should check the historical Current Ratio of a company (as well as its peer group) when evaluating what a good ratio is.
What Does a Current Ratio of 1.5 Mean?
A Current Ratio of 1.5 means that the company has 1.5x more current assets than current liabilities. Ideally, a ratio between 1.5 and 2 is considered healthy, as it suggests that the company can comfortably cover its short-term obligations while still having some buffer.
What Happens If the Current Ratio Is Less Than 1?
If the Current Ratio is less than one, it means that the company has more current liabilities than current assets. This situation can be a red flag, indicating potential liquidity issues. The company might struggle to meet its short-term obligations, which could lead to financial distress or even insolvency if not addressed. This may be a temporary anomaly in the company’s operations or it may suggest that the company has increasing liabilities due, and does not have sufficient current assets to cover these obligations.
Conclusion
The Current Ratio is a vital liquidity ratio that provides a quick snapshot of a company’s financial health. By comparing current assets to current liabilities, it helps assess the company’s ability to meet its short-term obligations.
A desirable Current Ratio is above one, indicating that the company has more current assets than current liabilities, which is a sign of financial stability. However, it’s important to consider the limitations of the Current Ratio, such as the varying liquidity of different current assets and the timing of cash inflows and outflows. Despite these limitations, the Current Ratio remains a valuable tool for investors, creditors, and management to make informed decisions about working capital management, risk assessment, and overall financial health.