Current Ratio Explained With Formula and Examples

What Is the Current Ratio?

The current ratio is a liquidity ratio that measures a company’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 higher is generally considered acceptable. A current ratio that is lower than the industry average may indicate a higher risk of distress or default. Similarly, if a company has a very high current ratio compared with its peer group, it indicates that management may not be using its assets efficiently.

The current ratio is called current because, unlike some other liquidity ratios, it incorporates all current assets and current liabilities. The current ratio is sometimes called the working capital ratio.

KEY TAKEAWAYS

• The current ratio compares all of a company’s current assets to its current liabilities.

• These are usually defined as assets that are cash or will be turned into cash in a year or less and liabilities that will be paid in a year or less.

• The current ratio helps investors understand more about a company’s ability to cover its short-term debt with its current assets and make apples-to-apples comparisons with its competitors and peers.

• One weakness of the current ratio is its difficulty of comparing the measure across industry groups.

• Others include the overgeneralization of the specific asset and liability balances, and the lack of trending information.

Formula and Calculation for the Current Ratio

To calculate the ratio, analysts compare a company’s current assets to its current liabilities.1

Current assets listed on a company’s balance sheet include cash, accounts receivable, inventory, and other current assets (OCA) 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.

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Understanding 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.

In many cases, a company with a current ratio of less than 1.00 does not have the capital on hand to meet its short-term obligations if they were all due at once, while a current ratio greater than 1.00 indicates that the company has the financial resources to remain solvent in the short term. However, because the current ratio at any one time is just a snapshot, it is usually not a complete representation of a company’s short-term liquidity or longer-term solvency.

For example, a company may have a very high current ratio, but its accounts receivable may be very aged, perhaps because its customers pay slowly, which may be hidden in the current ratio. Some of the accounts receivable may even need to be written off. Analysts also must consider the quality of a company’s other assets vs. its obligations. If the inventory is unable to be sold, the current ratio may still look acceptable at one point in time, even though the company may be headed for default.

Interpreting the Current Ratio

A ratio under 1.00 indicates that the company’s debts due in a year or less are greater than its assets—cash or other short-term assets expected to be converted to cash within a year or less. A current ratio of less than 1.00 may seem alarming, although different situations can negatively affect the current ratio in a solid company.

For example, a normal cycle for the company’s collections and payment processes may lead to a high current ratio as payments are received, but a low current ratio as those collections ebb. Calculating the current ratio at just one point in time could indicate that the company can’t cover all of its current debts, but it doesn’t necessarily mean that it won’t be able to when the payments are due.

Additionally, some companies, 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 relative to its receivables balance. Large retailers can also minimize their inventory volume through an efficient supply chain, which makes their current assets shrink against current liabilities, resulting in a lower current ratio. Walmart’s current ratio as of July 2021 was 0.96.23

In theory, the higher the current ratio, the more capable a company is of paying its obligations because it has a larger proportion of short-term asset value relative to the value of its short-term liabilities. However, though a high ratio—say, more than 3.00—could indicate that the company can cover its current liabilities three times, it also may indicate that it is not using its current assets efficiently, securing financing very well, or properly managing its working capital.

The current ratio can be a useful measure of a company’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 calculated repeatedly over several periods.

What Is a Good Current Ratio?

What counts as a good current ratio will depend on the company’s industry and historical performance. Current ratios of 1.50 or greater would generally indicate ample liquidity. Publicly listed companies in the United States reported a median current ratio of 1.94 in 2020.7