The current ratio is one of the liquidity ratios which measures a company’s ability to pay its short term liabilities with its assets. This is a good way to measure overall liquidity as short-term liabilities are due within the next year, giving the company only a short amount of time to raise funds to pay those liabilities.

You can also use the quick ratio formula, which is very similar, to measure the ability of the company to pay its liabilities with the most liquid assets.

Companies which have a larger amount of current assets would be more secure in paying off current liabilities when due without having to sell more long-term, and possibly revenue generating, assets.

How to calculate current ratio?

The current ratio is calculated by dividing current assets by current, short-term liabilities.

Current\; Ratio = \frac{Current\; Assets}{Current\; Liabilities}

Current assets include:

  • Cash
  • Cash Equivalents – Treasury Bills, Commercial Papers, Money Market Funds and Short-Term Government Bonds
  • Marketable Securities – financial instruments, such as stocks, certificates of deposit or bonds with a maturity date of 1 year or less, that are easily sold or bought on public exchanges
  • Short-Term Investments
  • Accounts Receivable – money owed to the company by customers that should be paid within a year
  • Prepaid Expenses
  • Inventory – materials, goods, products, packaging, etc.

Current liabilities are a company’s debts or obligations that are due within one year. Current liabilities include:

  • Short-term debt
  • Current portion of long-term debt – a portion of a long-term debt that has to be paid within a year
  • Accounts payable – money for purchasing goods or services by the company that should be paid within a year
  • Accrued liabilities – taxes or interest payable

 Current and Long-Term assets and liabilities are separated on the balance sheet, which allows to easily calculate financial ratios including liquidity ratios. On the balance sheet accounts are presented in the order of liquidity, so short-term accounts are always presented before long-term accounts.

Analysis of the current ratio

The Current Ratio illustrates how easily the company will be able to pay off its current liabilities. For example, CR of 2 means a company has $2 of Current Assets for each $1 of Short-Term Liabilities. Current Ratio of 0.5 means that a company has two times less Current Assets than Current Liabilities.

Generally, if the Current Ratio is less than 1, a company may have problems paying its Short-Term Liabilities. Nevertheless, acceptable Current Ratio values depend on the industry a company operates in.

For example, some companies can have a higher receivables turnover than payables turnover. Other companies, which operate in retail industry, tend to collect payables very quickly from their customers but have a long time to pay their suppliers. That means, the companies have to be compared within the same industry.

In theory, the higher the Current Ratio, the easier a company makes current debt payments. However, if the Current Ratio is very high that suggests that the company keeps too much resources in Current Assets instead of investing it and generating profit. On the over hand, profit maximization is one of the top priorities of any business and if the company invests all the money, it won’t have enough cash to run its daily activities, i.e. pay salaries, tax, rent, etc. Relationship between profitability and liquidity can be described as inversely proportional. The higher the liquidity the lower will be the profitability and vice versa. So, one of the important tasks for a financial manager, is to find the balance between liquidity and profitability.

Example of Current Ratio Calculation

BALANCE SHEET
Current Assets   Current Liabilities  
Cash $50,000 Accounts Payable $40,000
Cash Equivalents $20,000 Accrued Expenses $30,000
Common Stocks $5,000 Short-Term Debt $30,000
Accounts Receivable $40,000 Current Portion of Long-Term Debt $25,000
Inventory $50,000
TOTAL $165,000 TOTAL $125,000
Current\; Ratio = \frac{\$165,000}{\$125,000} = 1.32

Current Ratio of 1.32 means that the company has enough Current Assets to pay its Current Liabilities. For each $1 of Short-Term Debt it has $1.32 of Current Assets.