Current Ratio Formula

What is the Current Ratio?

Current Ratio, also called the working capital ratio, is a financial indicator that is used to assess a company's short term liquidity. The ratio can be calculated by dividing the total current assets of a company by its total current liabilities

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It is used by investors to analyze a company's ability to pay off short-term obligations to lenders. A higher ratio means that the company has a very good short term liquidity position and can meet all short-term liabilities. On the other hand, a low ratio could be an indicator of trouble and illiquidity in the company's finances. Hence, the current ratio is used to reveal the company's short-term solvency health.

Formula for Current Ratio

The current ratio compares the size of the current assets of a company to its current liabilities. Calculated by dividing the amount of current assets by the amount of current liabilities and is summarized by the following formula:

Current Ratio = Current Assets / Current Liabilities

Below, we discuss in brief detail what current assets and current liabilities are, as well as where you can find them on the balance sheet.

Current Assets

Current assets are all assets that a company can liquidate into cash within a year. Examples of current assets include: 

  • Cash and Cash Equivalents - These are any assets that are cash or can be converted to cash almost immediately. Cash serves as an important tool to pay off short and long-term debt. It is also important for investing in capital expenditures and acquisitions.  
  • Marketable Securities - Assets that can be liquidated quickly. Marketable securities include stock, bonds, and treasury bills. 
  • Accounts Receivable - It represents the cash owed to a company by its lenders. Accounts receivable are expected to become cash in under 12 months. 
  • Prepaid Expenses- A payment that is made in advance by a company for an expense cost. 
  • Inventory-  The raw materials used to produce goods and finished goods that are ready for sale. 

wall-street-oasis_financial-dictionary_current-ratio_current-assets

Current Liabilities

A current liability refers to a company's obligations or debts that are due within one year. Current liabilities are found on its balance sheet. Current liabilities include:

  • Short Term Debt- Financial obligations to lenders that are expected to be paid off within a year.
  • Current Portion of Long Term Debt- Amount of unpaid principal from long-term debt that has accrued during the operating cycle. 
  • Accounts Payable- Obligations owed to suppliers that are to be paid within 12 months. 
  • Accrued Liabilities- Expenses incurred but not yet paid for. 

Combining these all factors the formula for a current ratio would be:

wall-street-oasis_financial-dictinary_current-ratio_current-ratio-formula

What is a financial statement and where to find them?

The three major financial statements are the income statement, balance sheet, and cash flow statements. Every public company must include the financial statements with the Security and Exchange Commission (SEC) regulator filings. Public companies are required to release quarterly and annual reports to the public. These reports are 10-Q and 10-Ks. Other than the three major financial statements included in these reports are:

  • Business Information- Provides a high-level overview of the business. Provides information about products and services offered by the company.
  • Risk Factors-  Any internal or external risk a company faces is listed in this section.  
  • Selected Financial Data - It is used by the company to highlight specific financial data to give a snapshot of its financial performance. 
  • Management Analysis- A section used to explain recent performance and provide guidance for the future of the company. 

wall-street-oasis_financial-dictinary_current-ratio_FedEX-annual-report

An effective way to understand financial statements is to think of financial statements like a food nutrition label. The three statements provide information about the company's past performance. A breakdown of the three major statements:

  • Income Statement- It presents the company's operating activities such as details about its revenues and expenses. It is used to determine the company's earnings and various other metrics related to profitability.
  • Balance Sheet- It presents information on the assets, liabilities, and shareholder's equity of a company. It usually presents them based on historic cost and not fair value. In a balance sheet, the total assets must equal the sum of liabilities shareholder's equity. Balance sheets provide investors information about a company's liquidity and solvency. All information to calculate a current ratio can be found on the balance sheet.
  • Cash Flow Statement- It presents all cash-related activities (cash outflows and inflows) undertaken during a given period. Is divided into three sections which are cash flows from operating, investing, and financing activities. Operating activities are those activities that deal with keeping the company's operations running. Investing activities include asset purchases and gains from sale of assets. Financing activities are focused on debt and stock issuance, and other obligations such as interest and dividends. 

All three financial statements are used to analyze a company's performance. Using the statements you can determine a company's value and forecast future performance. Financial statements are an integral tool to understand a company's performance and position.

The three financial statements for publicly-traded companies are published both on a quarterly and annual basis. These reports can be found in two places. The first is the SEC EDGAR database. The other is on the company's website on the investor relations page.  

Example of Current Ratio

Let's look at an example to understand how to calculate the current ratio of a company.

In this example, we look at information from Apple's (APPL) Balance Sheet for the fiscal year 2020. 

Below is Apple's balance sheet for the fiscal year 2020. The balance sheet can be found in the annual 10-K report which is listed in the SEC EDGAR database and Apple's website under investor relations. On the balance sheet are the current assets and current liabilities.  

On the balance sheet, you can find the total value of current assets and current liabilities, which is used to find the quick ratio. Above those two values is a breakdown of all types of current assets and liabilities.

wall-street-oasis_financial-dictonary_current-ratio_AAPL-balance-sheet

In 2020, Apple's current assets were $143.7 billion. Also in 2020, Apple's current liabilities were $105.4 billion. Using these numbers in the ratio formula, $143.7/ $105.4, we can determine that its current ratio is 1.36. 

Analysis of Current Ratio

Understanding the working capital ratio is important for any investor to evaluate a company's financial health. Typically, a ratio higher than 1 is considered a healthy benchmark. A ratio higher than 1.0 tells an investor that a company can support its current liabilities using its current assets while a ratio under 1 tells investors that a company will struggle to pay short-term obligations.

When evaluating a company's working capital ratio, it is important to look at how the ratio changes over time. If a company is having positive annual growth of current ratio, it is a positive sign which means that the company is maintaining a stronger balance sheet. On the other hand, if a company is having a negative growth of the ratio, it could be an indicator that the company is struggling to meet obligations to lenders.

Comparing a given company's working capital ratio to other companies in a similar sector or industry is the best way to use the ratio. For example, comparing Apple's (APPL) 2020 current ratio of 1.36 against Microsoft's (MSFT) 2020 current ratio of 2.58 helps us determine that Apple's ratio is weaker compared to its competitor.

To understand a company's working capital ratio, it is crucial to understand what a healthy ratio is, evaluate its past growth, and compare it to other similar companies.  

wall-street-oasis_financial-dictionary_current-ratio_financial-health

Changing Current Ratio over time

Other than just accessing the current ratio on a standalone basis, investors can also analyze changes in the ratio over a period of time. 

For instance, a current ratio of 0.8 is a weak value. But if your current ratio two years ago was 0.4 and last year it was 0.6, the 0.8 does not look as bad. Increase in current ratio over time is a sign of healthy growth for a company.

On the flip side, a current ratio of 1.1 is a healthy value. But if you examine previous years and see it was 1.8 two years ago and 1.5 last year, it looks much less healthy. The change in ratios means the company is actually performing worse in terms of financial health over time.

Below, we look at an example of two companies to understand this concept. 

Company X has had a positive change in the current ratio while company Y has had a negative change in the current ratio over the past 3 years.

The table below presents the current ratios of the companies for the year 2019, 2020, and 2021.

From the table, it is very clear that company X has been improving its financial position (as determined by its current ratio) while company Y has had a deteriorating run.

Hence, it is important to compare the current ratio of a company to not just its peers, but also itself from past periods.

wall-street-oasis_financial-dictionary_current-ratio_changing-current-ratio

Is a current ratio of 1.5 Good?

A current ratio of 1.5 means that the company has $1.50 in current assets for every $1 it has of current liabilities. 

For example, a company may have $300 million of current assets and $200 million of current liabilities. Using the current ratio formula ($300 million / $200 million) would mean a current ratio of 1.5.

A ratio of 1.5 is usually considered to be a strong current ratio, well above the benchmark of 1. It tells investors that a company should not have any issues meeting its short term liquidity requirements.

Uses of Current Ratio

For prospective investors, one use of the working capital ratio would be while performing a comparable analysis as part of which, the ratio of a target company is compared against its peer companies.

For internal use, management can use the metric to make decisions about business operations and working capital. The metric allows management to adjust operations to improve methods to pay off its short-term debts. If a company is unable to pay off its short-term debt it can face a liquidity crisis and in extreme cases bankruptcy.

wall-street-oasis_financial-dictinary_current-ratio_internal-current-ratio-

Limitations of Current Ratio

While the current ratio is an effective measure of the short term liquidity of a company, it is important to use other liquidity measures when evaluating a company. The current ratio is unable to provide a prospective investor with other important metrics such as solvency, profitability, and growth metrics. 

For instance, a company may have a healthy current ratio and you could presume the company would then have healthy liquidity and solvency. But sometimes, companies will hold cash before making a large investment in capital expenditures

During this time a company may have a healthy working capital ratio but poor solvency ratios. When evaluating a company's value, it is important to look at multiple ratios relating to liquidity, solvency, and profitability.

Another limitation of the ratio is inventory issues. If a company has an aged inventory, it can significantly impact the ratio. While aged inventory is not a good component to have in your business, it would still help increase the current ratio. 

Inventory is included in the numerator of the equation, so a higher inventory naturally leads to a higher ratio. This would allow a company with aged inventory to use it to its advantage. 

Here is an example of two companies with the same working capital ratio but one with an aged inventory and one without:

wall-street-oasis_financial-dictionary_current-ratio_comparing-current-ratio

As we see in the example above, the working capital ratio for Company Y is misleading. It presents a ratio of 2.1 which is a healthy value for a company. But, by examining its balance sheet, we understand that the ratio is high because of Company Y's high inventory. Company X has the same ratio, but a much healthier distribution between current assets.

Current Ratio vs Quick Ratio

A common misconception that prospective investors make is not understanding the difference between current ratio and quick ratio. But, the ratios are calculated differently and give two different measures of short-term liquidity.

To calculate the quick ratio, you only include current assets that can be liquidated to cash within 90 days. This includes:

Short term liabilities remain the same for both current ratio and quick ratio. Given this information, the formula for quick ratio is:

wall-street-oasis_financial-dictionary_current-ratio_formula-quick-ratio

Because of the adjustments to current assets in quick ratio, it is considered to be a more conservative liquidity metric. It helps to assess a company's ability to pay off liabilities almost immediately. When using the current ratio you are assessing the ability to pay off liabilities in under a year.

Another important distinction is that the quick ratio addresses the shortcomings of the current ratio by eliminating the effects of inventory. As we have described in the previous section, aged inventory can be used to manipulate the current ratio. However, it is not possible to use the same tactic to manipulate the quick ratio.

Takeaway of Current Ratio

Current ratio is a useful measure to evaluate a company's liquidity position. It is used by investors to analyze a company's ability to pay off its short-term obligations to lenders. 

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