The Current Ratio: Formula, What It Is & How to Calculate It

The current ratio is a financial term that refers to the relationship between two ratios. In this article, we’ll explain what it is and how you can calculate it.

The current ratio, also known as the working capital ratio, determines whether a company’s current assets are enough to pay its current obligations. A higher figure implies stronger short-term financial health, and a ratio of 1-to-1 or better shows that a company’s current assets are sufficient to pay its short-term obligations without the need to liquidate fixed assets.

What is the Current Ratio and How Does It Work?

The current ratio, like the quick ratio and cash ratio, is a liquidity ratio that is used to compare a company’s current assets. Current assets are assets that can be converted to cash within a year, while current liabilities are obligations that are due within a year. Businesses and investors may use the current ratio to see whether they can meet their commitments using current assets rather than selling fixed assets or raising capital.

The Formula for the Current Ratio

A company’s current assets are divided by its current liabilities using the current ratio formula. Current assets comprise both liquid and non-liquid assets such as inventories, while current liabilities include short-term obligations such as payroll taxes and immediate payables such as accumulated salary.

The current formula for calculating ratios is as follows:

Assets in Use / Liabilities in the Present = Current Ratio

Current Assets

Any balance sheet item, including liquid assets, that may be converted to cash within a year is considered a current asset. Cash and cash equivalents, as well as accounts receivable and marketable securities, are considered liquid assets since they are expected to be converted to cash within a year.

The following are some instances of current assets:

• Any money in checking or savings accounts, any coins or currency (such as petty cash), and any bank drafts or money orders are all considered cash.
• Cash equivalents; include marketable securities, short-term government bonds, and treasury bills, as well as any short-term promissory notes due to the business.
• Accounts receivable (AR); refers to any money owing to you by consumers for products or services purchased on credit.
• Inventory; refers to a company’s assets that are meant to be sold to end customers. This may comprise both completed goods and raw materials to be utilized in the production of a company’s goods.

What Isn’t Counted Among Current Assets?

Assets that cannot be turned into cash within a year are not considered current assets. These assets are known as fixed assets, and they comprise plant, property, and equipment that are not sold or otherwise consumed by a company during regular operations.

The following are some instances of assets that are not included in current assets:

• Property; refers to any buildings, land, or other real estate owned by a company.
• Any machinery; technology such as computers and servers, and other equipment not considered part of the company’s inventory is termed equipment.
• Vehicles: Any automobiles, trucks, or other titled vehicles held by a business but not included in its inventory are called vehicles.

Current Liabilities

The phrase “current liabilities” refers to a company’s short-term financial commitments that are due immediately or within one year. Accounts payable, income and payroll taxes, short-term loans, and current maturities of long-term debt are examples of these obligations.

The following are some instances of current liabilities:

• Accounts payable (AP): Accounts payable refers to any short-term commitments, such as debts to creditors, merchants, and suppliers.
• Sales taxes, income taxes, and payroll taxes are all examples of taxes.
• Payroll refers to all monies due to workers, such as salaries, wages, bonuses, and commissions.
• Any short-term loans or current maturities of long-term obligations are examples of current loan liabilities.

What Doesn’t Appear in Current Liabilities?

Any long-term financial commitments not due within a year are not included in current liabilities. Permanent commercial loans, such as mortgages on newly constructed commercial buildings, other long-term loans, long-term leases, bonds, and debentures are examples of these.

What Does the Current Ratio Mean?

The current ratio of a company may be easily deciphered. The greater the ratio, the more probable a company will be able to fulfill its short-term financial commitments. Any ratio higher than one-to-one shows that a company can cover current obligations with current assets at the very least. A ratio of less than one-to-one, on the other hand, implies that a company’s existing short-term commitments cannot be met without selling fixed assets, making fresh sales, or raising money in some other manner.

What Does a Good Current Ratio Look Like?

A decent current ratio is difficult to define, as it may vary depending on the industry. As the name implies, a company’s current ratio is continuously changing owing to continuing payments to creditors, liquidation of assets, sales, and other sources of income. As a result, businesses prefer to aim for a range rather than an exact percentage.

A ratio of 1.2-to-1 to 2-to-1 is generally considered a sign of a strong firm by investors and other experts, showing a company’s capacity to pay short-term obligations while also investing a good proportion of its working capital. A current ratio of more than 2-to-1 indicates that a business is not effectively investing short-term assets.

The Importance of the Current Ratio

The current ratio is a valuable tool for companies and investors because it provides instant insight into a company’s short-term financial health and provides early warning signals that it is not utilizing its working capital effectively. It also alerts a company’s management and investors that existing assets are insufficient to pay current obligations.

A positive current ratio may also assist a business get better credit conditions when it needs to borrow money. Aside from creditors, the current ratio informs outside investors and corporate stakeholders about a firm’s ability to meet current commitments while maintaining day-to-day operations.

Other Liquidity Ratio Examples

Liquidity ratios are a kind of computation that may be used to assess a company’s capacity to meet short-term commitments. They may be used by investors and creditors to determine whether or not to provide funding, in addition to being utilized by corporate stakeholders to assess the financial health of the organization. The current ratio, quick ratio, and cash ratio are the three most popular liquidity ratios.

The Quick Ratio compared to the Current Ratio

The quick ratio, also known as the acid-test ratio, is extremely similar to the current ratio and uses the same basic formula. The quick ratio does not include inventory in a company’s current assets, which is the main difference between the two.

The reasoning is that inventory may be difficult to sell quickly, and doing so could result in a loss. It is frequently used to assess the financial health of firms that have a high proportion of current assets in inventory, such as retail and manufacturing. One of the most common criticisms of the quick ratio is that it overestimates the difficulties of selling goods fast at market pricing.

The Cash Ratio vs. the Current Ratio

The cash ratio is the most conservative liquidity ratio, and it is computed in the same manner as the current and quick ratios, but without inventory and accounts receivable.

This cautious method, like the fast ratio, is based on the fact that inventory and accounts receivable may be difficult to convert to cash, inflating a company’s apparent capacity to pay short-term commitments. The cash ratio has been criticized for being overly cautious, underestimating a company’s capacity to sell goods and collect accounts receivable.

The Benefits and Drawbacks of Using the Current Ratio

The current ratio is a helpful measure for assessing a company’s short-term financial health by determining its capacity to pay current obligations with current assets. However, although it is a basic and useful model for many organizations, it may fall short of properly assessing the financial health of enterprises with certain kinds of assets or in specific sectors.

Advantages

The following are some of the benefits of using the current ratio:

• A simple assessment of financial health: One of the main advantages of the current ratio is its ease of computation, which allows it to be used as often as required to assess a company’s current financial health.
• Aids in the measurement of asset-to-cash conversion efficiency: A business may monitor its efficiency in converting assets to cash and predict future performance by calculating the current ratio and tracking it over time.
• When should a business invest existing assets vs. keep them? Tracking the current ratio may help a business decide whether to invest or hold current assets in order to maintain the ratio in the appropriate range.
• Demonstrates the capacity of a business to fulfill its debt obligations: The current ratio provides creditors with a simple metric to use when deciding whether or not to provide credit or debt to a business based on its capacity to fulfill current obligations.

Drawbacks

The following are some of the present ratio’s drawbacks:

• For inventory-heavy current assets, the following findings are misleading: It may overstate a company’s capacity to sell assets at market price by adding inventories.
• It’s possible that you’re overestimating your capacity to collect on accounts receivable (AR): The present ratio does not account for the time it takes to collect AR and does not properly identify AR that is a danger of default.
• Businesses with seasonal sales variations may have a very high current ratio during certain months and a very low current ratio during others, which may lead to misleading statistics.
• Not a reliable indication of asset quality: Some assets (for example, obsolete inventories) may be difficult to sell at market price and may need to be sold at a loss.
• The current ratio, like the majority of ratios, is readily modified. Overvalued inventory, for example, may increase the current ratio, which can be used to borrow money that the company may struggle to return.

What Can Be Done to Improve the Current Ratio?

A business may increase its current ratio by taking a number of measures. Depending on whether the present ratio is within or above the desired range, the appropriate approach may vary. Businesses may use these methods to improve accounts receivable collections, sell fixed assets, save expenses, manage accounts payable, and invest assets, among other things.

The following are some of the most popular methods for increasing the current ratio:

1. Get rid of long-term assets.

Many companies own long-term assets including commercial real estate and buildings, as well as manufacturing equipment. If a company’s current ratio falls below the goal, it may consider selling long-term assets that are no longer required, such as underperforming buildings or underused assets with resale potential. The business will be able to boost cash on hand as a result, improving the current ratio.

2. Refinance any short-term debt you may have.

A business may move part of the associated liability out of its current liabilities on its balance sheet by refinancing short-term debt obligations (for example, term loans with a six- to 12-month payback period) into long-term debt. To keep the ratio in check, businesses that take on extra debt should choose long-term debt over short-term debt.

3. Cut Down on Overhead Expenses

Monitoring and evaluating a company’s short-term fixed and variable expenditures on a regular basis enables companies to use active methods to reduce these costs via improved procedures and budget management. Reducing travel costs, renegotiating vendor and supplier contracts, and controlling department operating expenses are just a few examples (OPEX). As a consequence, the amount of cash on hand in the company’s checking account, which is considered a current asset, rises.

Conclusion

The current ratio is one of three popular liquidity measures that creditors and investors use to assess a company’s short-term financial health. A current ratio of less than one implies that a company’s current obligations may not be covered by current assets. A current ratio of more than 2-to-1 may suggest that a business is not using its short-term assets effectively. A current ratio of 1.2-to-1 to 2-to-1 is considered healthy in general.