# Current Ratio Formula

It evaluates a company's ability to meet its immediate financial obligations by comparing its current assets and liabilities

Author: Rishit Danani
Rishit Danani
Currently pursuing Bachelor's of Financial Markets (BFM) from H.R. College of Commerce and Economics.
Reviewed By: Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Last Updated:November 28, 2023

## 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

• 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.

•  Current assets include cash, receivables, and inventory; current liabilities include payables and short-term obligations.

• 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

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:

1. 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.
2. 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.
3. 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,
4. 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.
5. 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.
6. 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.
7. 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

Researched and Authored by Rishit Danani | Linkedin

Reviewed & Edited by Ankit SinhaLinkedIn