What Is The Current Ratio And How Do You Calculate It?

What is the meaning of current ratio?

The current ratio is an accounting tool that assesses a company’s ability to pay off its debts in the short term. In financial terms, ‘current’ refers to a period of a year or less. The current ratio – also called the working capital ratio – is, therefore, a comparison of a company’s current assets and current liabilities.

Current assets fall under the following categories:

• Cash and cash equivalents, including ready cash, coins, currency, undeposited cheques, and the balance in a company’s business accounts. 
• Marketable securities, such as stocks and bonds.
• Accounts receivable, or money a company is owed by customers and clients. 
• Inventory, which includes the stock of goods sold by a company as well as the material used to produce and package those goods.
• Other current assets, which are assets that don’t warrant their own category, such as real estate, equipment, income tax refunds, and prepaid expenses (utility bills, rent, taxes, etc).

Similarly, current liabilities include:

• Accounts payable, or money a company owes its suppliers, customers, creditors, etc.
• Short-term debt, such as loans with fixed interest rates that are due within a year.
• Accrued expenses, such as wages, rent, taxes, utility bills, and interest that have been incurred but are yet to be paid.
• Deferred revenue or unearned revenue, which includes payments received in advance from customers and clients for goods and services that are to be delivered at a later date.
• Other current liabilities, or miscellaneous unpaid fees and expenses.

Why is the current ratio important?

The current ratio is a snapshot of a company’s financial health at a given time. A higher ratio implies healthy finances while a lower ratio indicates the opposite. By analysing and interpreting your company’s current ratio, you can gain insights into your operations and make improvements if and where required. For example, you can use your current ratio to check how effectively your company manages inventory. Are you selling your goods in a manner that brings in regular revenue or is your stock gathering dust for long periods of time? Addressing shortcomings in your inventory management will not only strengthen your current assets but also help you avoid losses (such as damage to goods) and save on unnecessary expenses (such as warehousing and storage fees).

Apart from business owners and finance teams, lenders and investors also have a keen interest in the current ratio. A company’s current ratio tells banks if it is capable of paying off its current debt and taking on more. A lender might even quote a threshold current ratio that companies must maintain in order to qualify for a loan. Similarly, investors might check the current ratio to decide if a company is worth investing in. The current ratio is also useful to suppliers, telling them if they can expect to be paid on time. Furthermore, potential customers and partners can use this metric to check if they can bank on a company to reliably deliver the goods and services they seek.

How to calculate current ratio

The current ratio formula is simple:

Current ratio = Current assets / Current liabilities.

Here is an example using the current ratio formula. Let’s say a small company has SGD 30,000 in current assets while it owes SGD 20,000 in current liabilities. The current ratio is, therefore, 30,000 / 20,000 = 1.5.
Note: The current ratio can be expressed in decimals, as shown in this example, or as a ratio. Here, the ratio would be 3:2. However, for simplicity, we will depict the current ratio in decimals for the rest of this article.

Detailed example of how to calculate current ratio

(Insert table)

Current ratio = 107,600 / 103,000 = 1.04

This means the company’s assets can just about cover its short-term liabilities.

How do you interpret the current ratio?

• A current ratio under 1 means that a company’s liabilities outweigh its assets. It indicates that the company is unable to pay its short-term debts using its current assets.
• A current ratio of 1 or a little above 1 shows that a company has just enough current assets to cover its debts that are due within a year.
• A current ratio of 3 or more means a company can take care of its current liabilities and still have money to spare. A current ratio of 3, for instance, indicates that it can pay its debts three times over.
• A current ratio of 1.5 to 3 is usually considered ideal.

However, while calculating, it must be remembered that the current ratio is only relevant to the time of calculation. Any change in a company’s assets and liabilities will result in a change in the current ratio too. So, if a company’s current ratio is below 1 at a given time, it does not mean it will remain the same in the coming weeks and months. In fact, the company might produce a healthier current ratio and have the assets required to cover its debts when they are due to be paid.

What is a good current ratio?

Now that we’ve dealt with the current ratio formula, the next question you might ask is: “What is a good current ratio?” There is no definitive answer to this question. Rather, the trick to using the current ratio is to know how to analyse it accurately. Here are three points to keep in mind:

1. A high current ratio isn’t necessarily good

While this does mean that a company can cover its short-term liabilities, it could also mean that it is not using its assets efficiently. It might be allowing its assets to lie idle instead of investing it in research and development and business expansion.

2. A low current ratio isn’t always bad  

A current ratio below 1 might seem alarming but could mean many other things, not all of them bad. It could mean that a company cannot cover its debts at the time of calculating the current ratio, but it might have the means to pay when the payment is due. A low current ratio could also mean that a company has yet to receive its payments but will certainly do so in the near future, following which the current ratio will also be corrected.

3. Inventory can distort the current ratio

Inventory is an important component of the current ratio. A small inventory might shrink the current assets account and, in turn, lower the current ratio. However, a small inventory could be a strength rather than a weakness, indicative of an efficient supply chain that doesn’t require a company to stock a large volume of inventory. In a reverse scenario, a large inventory might inflate the current assets account and, consequently, the current ratio. But this inventory might be old, unsellable, and a liability. One must also consider the fact that companies buy inventory for a lower cost and sell it for a higher price. This gap also has a bearing on the current ratio.

How does the current ratio change over time?

The current ratio is not a constant figure but one that ebbs and flows depending on various scenarios. So, to find out what is a good current ratio for a company – whether it is your own or one you have a professional interest in – you must monitor its current ratios over a longer period of time. If a company’s current ratio shows consistent improvement over time, it might be suggestive of a good opportunity to invest in it or do business with it. However, if the current ratio shows great volatility over time, going through leaps and drops, it could be a sign of a business struggling with operational risks.

While the current ratio is certainly a useful metric, your business decisions will be more informed if you use it together with other liquidity ratios, such as the quick ratio, cash ratio, and days sales outstanding (SDO). A liquidity ratio is a metric that measures a company’s ability to pay off its current liabilities without raising external funds.

Current Ratio vs. Quick Ratio: What is the Difference?

Like the current ratio, the quick ratio measures whether a company can pay its current liabilities with its liquid assets and is an indicator of financial health. However, it is slightly different from the current ratio as it does not account for inventory or prepaid expenses.

Quick Ratio Formula

The quick ratio formula is as follows:

Quick ratio = Current assets excluding inventory and prepaid expenses / Current liabilities

The quick ratio is often considered a more conservative metric as it takes into account only the most liquid assets that can be easily converted to cash. It is most useful when you need to analyse a company over a short time frame or one that trades in inventory that is at risk of going obsolete in quick time (such as electronics). The quick ratio is also called the acid-test ratio.

Current ratio vs cash ratio

The cash ratio compares cash and cash equivalents to current liabilities. It measures a company’s ability to pay its current liabilities using only its cash assets. This metric is used when a business is completely dependent on its cash reserves to clear short-term liabilities.

The cash ratio formula is:

Cash ratio = Cash and cash equivalents / Current liabilities.

Current ratio vs days sales outstanding

Days sales outstanding (DSO) measures the number of days on average it takes a business to collect payment on sales. To calculate the DSO, divide the total accounts receivables for a given period by the total value of credit sales for the same period, and then multiply the result by the total number of days in that period. A high DSO indicates payment delays while a low DSO shows payments are quick and on time. Therefore, the DSO gives a fair idea of a company’s cash flow position at any given time. The DSO can be calculated on a monthly, quarterly, and annual basis.

Limitations of the current ratio

1. Unlike other liquidity ratios, the current ratio lacks specificity. It includes all of a company’s current assets, but the reality might be that some of these assets are difficult to convert into cash in the short term. Inventory and accounts receivable, for example. The inventory might be old and unlikely to sell while some accounts receivable might be marked as bad debt that the company does not expect to collect and will eventually have to write off. If the current ratio is calculated using such inaccurate data, it will present a flawed picture of the company’s short-term liquidity. In the current ratio vs quick ratio debate, the quick ratio scores over the current ratio because it specifically includes only assets that are easy to liquidate.
2. A healthy cash account – a company’s most liquid asset – might still produce a misleading liquidity report. This can happen if some of the cash is set aside as working capital to take care of the business’ daily operations or reserved for a specific purpose (such as designing a new product).
3. Another flaw in using the current ratio is seen when comparing businesses. Even if two companies in the same industry have the same current ratio, their financial position at that point of time might be vastly different. While the total value of their current assets might be the same, one company might have more cash in hand while the other might have a large stock of old inventory that will not sell any time soon.
4. Yet another limitation of the current ratio has to do with the quality of its data. If the data is made up, the result will naturally be inaccurate.

What these shortcomings tell us is that relying solely on the current ratio to determine a company’s financial health is unwise. A better practice would be to use the current ratio alongside similar metrics such as the cash ratio and the quick ratio and also study historical trends and profit margins to come to a more reliable and precise conclusion.

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