The current ratio is a calculation that shows whether a company has enough resources to cover its debts over the next twelve months, i.e. it is a measure of its liquidity over the short term. It compares a business’ current assets (assets, including cash, that will be converted to cash within a year) with its current liabilities (debts due to be paid within a year).
Current Ratio = Current Assets ÷ Current Liabilities.
This calculation should not be confused with the quick ratio, which excludes inventory (stocks) from the equation.
Imagine a fictitious company has assets of $200 million and current liabilities of $160 million. Its current ratio is 250m ÷ 160m = 1.56.
The current ratio tells us whether a company might have trouble paying off its short-term debts.
What is an acceptable current ratio varies from industry to industry. Companies with a current ratio between 1.5 and 3 are generally seen as ‘healthy’, meaning they have good short-term financial strength.
When current asset ratio is too high or low
If the current asset ratio is less than 1, i.e. current liabilities are greater than current assets, the company may find it hard to meet its short-term obligations.
A very high current ratio (greater than 3) may attract criticism that the management is not using current assets efficiently. It could also be a sign of problems in working capital management. If it has too much cash it should consider either reinvesting more on growth or returning some of it to shareholders.
In some businesses, especially where inventory turns over much faster than the accounts payable become due, current ratios may be low, but the company is doing well.
A company with a low current ratio might be able to increase it rapidly, either by producing more and boosting its inventory, or if it has a good credit rating by taking on a long-term debt and boosting its cash levels.
Any company’s ratio should be compared to those of other businesses in the same sector.
In most situations a creditor who expects to be paid back within the next year will be happier with a debtor that has a high current ratio than a low one.
The Nasdaq Business Glossary defines current ratio as an:
“Indicator of short-term debt-paying ability. Determined by dividing current assets by current liabilities. The higher the ratio, the more liquid the company.”
Video – What is current ratio?