Current Ratio Formula
It evaluates a company's ability to meet its immediate financial obligations by comparing its current assets and liabilities
What Is The Current Ratio?
The current ratio is a liquidity ratio that assesses the ability of a company to meet its short-term commitments, those due within one year.
It is calculated by dividing a company's current assets by its current liabilities. Current assets include items like cash, accounts receivable, and inventory, while current liabilities consist of obligations due within the next year, such as accounts payable.
This ratio is also known as the working capital ratio. An acceptable current ratio typically aligns with industry standards, or slightly exceeds them. If a company's current ratio is on par with the norm, it implies a healthy ability to meet short-term financial commitments.
Certain factors can affect the interpretation of this liquidity ratio. For example, a company may have a high current ratio but aging accounts receivable, indicating slow customer payment or potential write-offs.
Creditors prefer a higher current ratio because it suggests a better chance of repayment. Yet, excessively high ratios may indicate inefficient use of assets or reliance on short-term financing, which might not be great news for investors.
If current liabilities exceed current assets, the current ratio falls below 1, signaling potential trouble in meeting short-term obligations.
However, there are exceptions. Some businesses can function well with a current ratio below 1 if they can turn inventory into cash faster than they need to pay their bills. In these cases, the actual cash generated from inventory sales may surpass its stated value on the balance sheet.
Key Takeaways
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The current ratio is a liquidity ratio assessing a company's ability to meet its obligations due within one year using its assets which can be converted into cash within one year.
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Current assets include cash, receivables, and inventory; current liabilities include payables and short-term obligations.
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A higher ratio suggests better liquidity, but an excessively high ratio may indicate resource inefficiency.
Current Ratio Formula
To calculate the working capital ratio, you divide the total current assets by the total current liabilities.
The formula is given as:
Current Ratio = Current Assets / Current Liabilities
This liquidity ratio is an important metric fundamental research analysts use to evaluate a company's liquidity and working capital management. It helps assess the company's ability to pay its short-term debts and obligations.
Current assets include resources that can be easily converted into cash within a year, such as:
- Cash
- Cash equivalents
- Short-term investments
- Accounts receivable
- Inventory
- Marketable securities
- Other receivables
- Prepaid expenses
Current liabilities are the company's obligations that are expected to be paid off within a year, including:
- Accounts payable
- Short-term debt
- Accrued expenses
- Notes payable
- Deferred revenue
- Taxes payables
Let's look at some examples showing the calculation of the current ratio.
Current Ratio Formula Example
Here, we will take a look at a couple of examples to understand the calculation of the current ratio and how to use the formula.
Let us understand by looking at an example:
The details below are an excerpt from ABC Limited’s balance sheet. We compute the company’s working capital ratio from the information below:
- Current assets = $100,000
- Current liabilities = $25,000
As per the current ratio formula,
Current Ratio = Current assets/ Current liabilities
= 100,000 / 25,000 = 4
Hence, the working capital ratio of ABC Limited is 4.
To understand the concept further, let us take example 2:
We will calculate the working capital ratio from the table given below of XYZ Limited’s balance sheet:
| Liabilities and Stockholders' Equity | Amount | Assets | Amount |
|---|---|---|---|
| Liabilities | Cash and Cash equivalents | $52,000 | |
| Deferred Revenue | $48,000 | Accounts Receivable | $85,000 |
| Accounts Payable | $48,000 | Inventory | $67,500 |
| Short-term Debt | $10,000 | Prepaid Expenses | $25,000 |
| Accrued Expenses | $13,000 | Property, Plant, and Equipment | $40,500 |
| Long-term Debt | $28,000 | ||
| Other Long-term Liabilities | $33,000 | ||
| Stockholders' Equity | $25,000 | ||
| Common Stock | $35,000 | ||
| Retained Earnings | $30,000 | ||
| Total Liabilities and Stockholders' Equity | $270,000 | Total Assets | $270,000 |
Here,
Current Assets = Cash & Cash Equivalents + Accounts Receivable + Inventory + Prepaid Expenses
= $52,000 + $85,000 + $67,500 + $25,000 = $229,500
Current Liabilities = Deferred Revenue + Account Payable + Short-term Debt + Accrued Expenses
= $48,000 + $48,000 + $10,000 + $13,000 = $119,000
We know that
Working capital ratio = Current Assets / Current Liabilities
= 229,500 / 119,000 = 1.92857 ≈ 1.93
Hence, the current ratio of XYZ Limited is ≈ 1.93.
Interpretation of The Current Ratio
In this section, we will see how we can interpret the working capital ratio:
High vs. Low Ratio
A higher working capital ratio suggests a better liquidity position; the company will not have to take loans to meet its short-term obligations. However, an extremely high ratio may indicate inefficient utilization of resources.
Note
The working capital ratio provides a snapshot and may not fully represent long-term solvency or short-term liquidity.
The points below show the interpretation of the current ratio with respect to numerical results obtained from the current ratio Formula.
- Current assets > current liabilities (Ratio > 1): Desirable situation indicating sufficient assets to pay short-term debts.
- Current assets = current liabilities (Ratio = 1): Current assets are just enough to pay short-term obligations.
- Current assets < current liabilities (Ratio < 1): A problematic situation is where the company lacks sufficient assets to pay short-term debts. Context and industry benchmarks play a role in evaluating a "good" ratio.
A ratio below 1 suggests potential insolvency, while a ratio equal to 1 is considered safe. However, investors may not always view a high working capital ratio favorably, as it could imply cash hoarding or lack of reinvestment.
For example, if the company hoards cash and does not distribute dividends to its shareholders or reinvests in a business on an infrequent basis, it may be regarded as having high ratios.
Note
Factors such as the quality of assets and efficient working capital management should be considered.
One example is that the business may have a ratio above one but with its accounts receivable older, perhaps because customers do not pay on time. It may be hidden in the calculation. There may also be a need to write down several accounts receivable.
In this respect, the quality of a firm's assets compared to its obligations needs to be taken into account by financial analysts. However, even if the company is at risk of default, relying on this liquidity ratio may still seem reasonable if an inventory cannot be sold.
Low Sales and Seasonal Stocks
Companies selling non-durable goods or having seasonal stocks may have volatile working capital ratios. Analyzing yearly patterns in these liquidity ratios is recommended.
The analysis of this liquidity ratio should not be limited to a specific period but should consider its trends over time. It is often observed that this ratio does not exhibit a consistent increase or decrease but instead follows a distinct pattern of seasonality.
Note
Seasonality is common in businesses associated with seasonal commodities, such as sugar and wheat.
These businesses typically make annual purchases of raw materials based on their availability, which are then consumed throughout the year. Such purchases require higher investments, often financed by debt, increasing the current asset side of the working capital ratio.
Therefore, when analyzing this liquidity ratio, it is crucial to consider the broader context and examine additional factors that may impact the company's overall financial position.
Limitations of The Current Ratio
The use of the working capital ratio has several limitations and constraints that should be taken into consideration, some of them are as follows:
- Industry Comparison: Comparing the current ratios of different firms across industries may not provide meaningful insights due to significant variations in financial structures and requirements. It is more beneficial to compare companies within the same industry.
- Lack of Specificity: This liquidity ratio includes all current assets, including those that cannot be easily liquidated. This can include inventory assets that may be difficult to convert into cash quickly and cash balances that are earmarked for specific purposes or restricted in their use.
- Minimum Cash Requirement: This liquidity ratio does not consider the minimum cash required for working capital needs. The ratio does not consider its ability to continue operations if the company's cash position falls below the necessary level,
- Reliance on Credit: A company may rely on a line of credit to make timely payments, even if its working capital ratio appears low. The existence of a credit line may help the company meet its short-term obligations, but this is still subject to concern in terms of its long-term ability to pay it off.
- Seasonal Sales and Inventory: Companies with seasonal sales often show fluctuations in their current ratio throughout their operating cycle. The inclusion of inventory assets can distort the liquidity measurement, especially if inventory levels are inflated or if the inventory turnover cycle is lengthy.
- Changes in Inventory Valuation: Changes in the inventory valuation method can impact the working capital ratio, even if they do not reflect a company's financial health or repayment capability. This factor adds complexity to the interpretation of the ratio.
- Potential Manipulation: This liquidity ratio can be manipulated by management. An equal increase or decrease in current assets and liabilities can influence the ratio, providing an inaccurate picture to investors and stakeholders.
It is important to consider these limitations and complement the analysis with other liquidity ratios and qualitative factors to understand a company's financial position comprehensively.
Current Ratio FAQs
A range of 1.5 to 2 is generally considered a good current ratio. However, note that the optimum Ratio can differ according to the industry in which an undertaking is active.
The current ratio is used to assess whether a company can meet its short-term obligations both immediately and on an ongoing basis.
When the working capital ratio is below 1.00, it may indicate that a company is facing difficulties in meeting its short-term obligations.
Conversely, a ratio above 1.00 suggests that the company may be able to pay its current debts when they are due. If a company's liquidity ratio is less than one, it has more bills to pay than available resources.
A current ratio of 3 means that for every $1 of current liabilities, the company has $3 of current assets.
In other words, the ratio is 3 if your company's assets include $200,000 cash and 100 000 in accounts receivable while its current liabilities are $100,000. This calculation divides the company's assets ($300,000) by its liabilities ($100,000).
Here we will examine the difference between the Current Ratio and the Quick Ratio, two financial ratios used to evaluate a company's short-term liquidity and ability to meet its obligations.
1. Current Ratio
- Measures the relationship between current assets and current liabilities.
- Assesses a company's ability to repay obligations within a fixed period.
- Considers all current assets that can be converted to cash within 12 months.
- A favorable ratio is generally around 2:1.
2. Quick Ratio
- Measures the proportion between highly liquid assets and current liabilities.
- Evaluates a company's ability to meet immediate obligations.
- Considers assets that can be quickly converted to cash within 90 days or less.
- A favorable ratio is generally 1:1.
Remember that these ratios provide insights into a company's liquidity position. Still, they should be analyzed with other financial indicators and factors specific to the industry and company in question.
A higher current ratio indicates a stronger ability to meet financial obligations. Conversely, a low current ratio suggests difficulties in repaying debts and liabilities. Generally, a ratio of more than 1 or at least 1.5 is considered favorable for a company, while anything below that is considered unfavorable or problematic.
The company may aim to increase its current assets, e.g., cash, accounts receivables, and inventories, to improve this ratio. A further improvement in the current ratio can be achieved by reducing existing liabilities, i.e., debts that are not repaid or payables.
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