What is the current ratio?
The current ratio is a liquidity ratio that measures a company’s ability to meet its short-term obligations. It is calculated by dividing the company’s current assets by its current liabilities.
A current ratio in line with the industry standard or slightly higher is considered acceptable. A lower than average current ratio may indicate distress or default risk and lower solvency ratios, which could make investment more worthwhile if there are significant assets on the balance sheet to use as collateral for loans.
A company’s current ratio is one of the most popular metric to assess liquidity. It must include all of a company’s existing assets and liabilities, not just the liquid assets and liabilities.
For example, a company with a current ratio of less than one may indicate liquidity problems that could cause it to go bankrupt. However, it still could secure other forms of financing if necessary.
Alternatively, a company with a high current ratio over 3 implies that it may not be using its existing assets as efficiently as possible. This could mean that the company is not managing its working capital properly.
How to calculate the current ratio
The current ratio is calculated by dividing a company’s current assets by its current liabilities:
Current Ratio = Current liabilities / Current assets
Current liabilities are due to be paid within one year, while current assets are cash and other liquid items that can be turned into cash within that same time frame.
The numerator and denominator of this calculation are found on a company’s balance sheet. The calculation results in a number that reflects how many times a company could pay its short-term obligations with its current assets.
This calculation can give investors or creditors an idea about how likely it is that the company will be able to repay its debts as they come due.
While other calculations can measure solvency, the current ratio is one of the most commonly used metrics because it’s simple and straightforward.
However, a current ratio is not the best indicator of which company would be a good investment because it changes over time and may not be accurate during specific business periods. For these reasons, investors need to look at other factors when deciding whether or not to invest in a particular company.
How to interpret the current ratio
The current ratio is a measure of liquidity that compares a company’s existing assets to its current liabilities. It’s an essential indicator of a company’s ability to meet its short-term obligations.
A high current ratio indicates that the company has more assets relative to liabilities and is better positioned to meet its obligations. On the other hand, a low current ratio means the company is less able to pay its short-term debts.
The current ratio can be interpreted in two different ways:
1) The most common way to use the current ratio is to compare it with historical data for the company and its peer group to understand whether or not the company has a short-term solvency issue.
2) The second way to use the current ratio is by looking at how it changes over time. This can give you insights into whether or not the company can negotiate longer payment terms with its suppliers, which would lead to a higher current ratio.
What is a good current ratio?
A good current ratio is 2:1 or higher, and this means that for every $2 in liabilities, the company has $1 or more in assets that can be used to pay off those liabilities.
Companies with low current ratios may struggle to meet their obligations, while companies with high current ratios may be less attractive to investors.
For example, publicly listed companies in the United States reported a median current ratio of 1.94 in 2022.
Current ratio drawbacks
The current ratio is a popular liquidity measure used to assess a company’s ability to pay its short-term liabilities with its short-term assets. While it has several advantages, the current ratio also has some drawbacks.
One shortcoming of the current ratio includes minimum cash for operations. This can be problematic because it does not consider the fact that some companies have restricted cash that is not always freely available for use by the business. In addition, short-term investments are not always liquid, which can make the current ratio more challenging to calculate.
Another drawback of the current ratio is management’s refusal to recognize bad A/R. When a company has accounts receivable that are unlikely to be paid, this should be reflected in the denominator of the calculation. However, many companies choose to exclude these amounts from their calculations to present a more favorable picture of their liquidity position.
The quick ratio is a more conservative measure of liquidity because it only includes liquid assets. This means that it does not include assets like inventory and prepaid expenses, which can be sold for cash but may take some time. The quick ratio only considers assets that can be sold for money within 90 days with a high degree of certainty. As a result, it is a more accurate measure of a company’s ability to meet its short-term obligations.