What Is Current Ratio?
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- The current ratio measures a company’s ability to pay its short-term liabilities within a year. It is calculated by dividing current assets by current liabilities.
- Low current ratios mean the business is sinking, while too high means the business is stagnating.
- Investors look for businesses with a current ratio between 1.5 and 3, which balances the low and high ends of the ratio.
What Does Current Ratio Show?
Current ratio (also called working capital ratio) shows whether a business has enough current assets to be converted to cash to settle its short-term obligations, such as debts and operating expenses. It is called “current ratio” because it considers current assets and current liabilities.
In other words, a company’s current ratio is a gauge of its financial health, particularly of the company’s liquidity. For example, if the current ratio is less than 1, they are (or will be) behind on their payments and cannot service their debt. Conversely, a ratio higher than 1 means they can pay their short-term liabilities with their short-term assets.
The formula to calculate the current ratio of a business is as follows:
Current ratio = current assets / current liabilities
Suppose a business has $260,000 in current assets and $52,000 in current liabilities. To get the current ratio, divide current assets ($260,000) by current liabilities ($52,000). In this case, the current ratio is 5.
This result means that the business can pay off its current liabilities with its current assets up to five times over.
Note that since current ratio is a snapshot in time, it is by no means a measure of an organization’s longer-term solvency. A business with a good current ratio now may still fail to pay off its liabilities the next year.
What Are Current Assets and Current Liabilities?
A business can find current assets and current liabilities on the company’s balance sheet.
Assets that can be converted to cash within one year are current assets. These assets include the following:
- Cash and cash equivalents. Cash includes money held in checking or savings accounts, undeposited checks, bank drafts, money orders, and petty cash. Cash equivalents are short-term securities the business can quickly sell, such as short-term government bonds and money market funds.
- Marketable securities. These are common stock and government and corporate bonds with a maturity period of one year or less. These include securities that the business can trade within three months.
- Inventory. These assets can be sold to end-users or stored by a business for future use. These include raw materials, finished products, unfinished parts, and manufacturing and packaging supplies.
- Accounts receivable. AR refers to money owed to a business for goods or services already delivered to customers.
- Prepaid expenses. These refer to advance payments for goods and services to be received in the future.
On the other hand, a business’s short-term obligations that it has to pay within one year are current liabilities. These include the following:
- Accounts payable or debt to creditors, vendors, and suppliers.
- Short-term debt.
- Short-term loans.
- Outstanding bill payments.
- Deferred revenue.
What Is a Good Current Ratio?
Generally, a current ratio between 1.5 and 3 indicates that a business is financially healthy. The higher the ratio, the more likely a company can pay its short-term obligations.
Note that the ideal current ratio will vary depending on the business and the industry in which it operates.
A current ratio of 1.0 means that a business’s current assets equal its current liabilities. That business has just enough assets to cover its short-term obligations, but it will also have not much else. In other words, this company is sinking and, therefore, a risky investment.
Worse still are businesses with ratios lower than 1.0. This ratio means it does not have enough assets to cover its debts and expenses. It is a sign that a business may have liquidity problems and is not financially stable.
Meanwhile, a current ratio higher than 1.0 means, at the very least, the company’s current assets will allow it to maintain some liquidity despite existing liabilities.
However, a very high current ratio is not always good news. For example, a current ratio greater than 3 can be a red flag for investors. On the other hand, ratios as high as this, or well above the industry average, may indicate that the company needs to manage its funds more effectively or that it is hoarding cash instead of investing in growth initiatives.
Why Use Current Ratio?
Investors use current ratio to determine if the businesses they want to invest in are financially healthy, which can make for good returns.
A low current ratio tells investors a business may not make enough money to pay for its operations. As a result, the business will struggle to raise capital to meet short-term obligations.
Businesses with low current ratios may also run out of money within a year. If investors put their money into such an organization, they might lose that money if that business collapses.
Conversely, investors are also wary of businesses with very high current ratios. So other than being a sign of mismanagement or stagnation, it may also mean a business has problems managing working capital.
Instead, investors want to find a balance between ratios, which fall between 1.5 and 3, which can mean high liquidity. As a result, these businesses can quickly pay off their debts, pay for their operations, and raise capital quickly for growth projects.
Current Ratio vs. Quick Ratio
Both ratios measure a business’s short-term liquidity. However, the quick ratio is more conservative because it only includes assets that can be converted to cash in 90 days or less.
Unlike the current ratio, the quick ratio excludes inventory, prepaid expenses, and other assets that take more than 90 days to be turned into cash.
To calculate quick ratio, divide the sum of all assets, excluding the categories mentioned, by current liabilities.
The quick ratio is always lower than the current ratio. The ideal quick ratio is 1 or higher because it means the business has enough liquid assets to pay liabilities due in 90 days.
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