What Is the Current Ratio? | altLINE (2024)

Contents hide

1 What Is the Current Ratio?

2 How Do You Calculate the Current Ratio?

3 How Does the Current Ratio Work?

4 What Are the Limitations of the Current Ratio?

6 Conclusion

Last Updated on June 23, 2023

The current ratio is an essential metric that small business owners, in particular, should keep a close eye on for their own company. It is also necessary for an investor to understand the current ratio in multiple companies when purchasing stock.

What Is the Current Ratio?

The current ratio is a commonly used metric in business, known as the working capital ratio. Generally speaking, the current ratio is a way of evaluating a particular company’s ability to pay short-term obligations.

What Is a Short-Term Obligation?

When looking at the current ratio, a company’s short-term obligation refers to any company’s payments within one year.

The current ratio compares assets within a company that can be converted to cash within a year to the liabilities it is also responsible for paying off within a year.

There are a few different liquidity ratios, the current ratio being one of them, that measure a company’s capacity to use its cash to meet the short-term financial needs. Other examples of liquidity ratios include:

  • Quick ratio, or acid test
  • Cash ratio

Related: How Much Working Capital Do I Need?

How Do You Calculate the Current Ratio?

You can calculate the current ratio of any company by dividing its existing assets by its current liabilities. The number this formula produces is the current ratio, which is equivalent to the number of times a company can pay its current financial obligations with its available assets.

The current ratio is significant because the higher the number produced from the formula is a vital indicator of the strength in the company’s current financial position.

Current Ratio = Current Assets / Current Liabilities

Current Assets

According to the balance sheet of a company, there are multiple different current assets. Current assets include:

  • Cash
  • Cash equivalents
  • Accounts receivable
  • Inventory

Cash Equivalents

Cash equivalents, which are considered a current asset, are different types of investments that will mature in less than three months and convert easily to cash. Examples of cash equivalents include:

  • Government bonds
  • Commercial paper
  • Money market funds

Accounts Receivable

Accounts receivable refers to the money that another company owes the primary company.

Inventory

Inventory includes the complete product within a company and the material used to create it.

Current Liabilities

On the other side of the ratio is current liabilities, which include:

  • Accounts payable
  • Income taxes payable
  • Wages payable
  • Dividends declared

Accounts Payable

Accounts payable are the amounts a company owes to suppliers at any given time.

Income Taxes Payable

Income taxes, much like individuals, are the taxes a company owes to the federal government.

Wages Payable

Wages payable include any wages that have been earned by employees but not yet paid by the company.

Dividends Declared

Dividends approved and declared by the company’s board of directors but have not yet been paid are known as dividends declared.

How Does the Current Ratio Work?

As a rule of thumb, investors look at current ratios below one to mean that the company might run out of money within the year. Alternatively, if they can show that they can increase cash flow or obtain additional investment capital, they might have the ability to sustain longer.

A higher current ratio in a company typically means no short-term liquidity concerns, which is a good thing for small business owners. An ideal current ratio for a company is two; a comfortable financial position for a company to be.

Keep in mind that acceptable ratios tend to vary amongst different industries. If you are dealing with industrial companies, a 1.5 may be adequate.

Some investors might believe that a company with a high current ratio is hoarding cash and not paying off dividends or reinvesting the money.

What Are the Limitations of the Current Ratio?

There are limitations when calculating the current ratio of a business. It is essential to look at each of them when determining whether it is a useful metric for your company.

1. Cash Conversion of Current Assets

One of the limitations involves accounts receivable and inventory. Because both current assets are not easily converted into cash, it is difficult to accurately determine a company’s short-term liquidity.

Cash Ratio

Instead of using current assets, the cash ratio looks at cash and cash equivalents only. Because these are the most liquid assets within a company, it can eliminate some of the limitations found when using the current ratio.

2. Business Seasonality

Additionally, for highly seasonal companies, the current ratio might not accurately depict the company’s liquidity.

3. Comparing Business to Business

Another limitation found in using the current ratio occurs when comparing businesses. Because there can be substantial differences amongst companies across different industries, it can become difficult to compare two against each other via the current ratio.

How Do You Calculate the Current Ratio in Excel?

There are multiple different Excel templates out there that will quickly help you keep track of your assets and liabilities. These templates will quickly calculate your current ratio at any given time, depending on the amount of information you provide.

An alternative way to calculate your current ratio in Excel would be to use the simple division formula. Place your current assets total in one cell, your current liabilities in another, and calculate the current ratio in another cell.

Ex: Current assets in cell A1, current liabilities in cell A2. In cell A3, type “=A1/A2” and hit [return] to calculate. The number in A3 will be your current ratio.

Conclusion

While the current ratio is a helpful metric for small business owners and investors, it is crucial to understand some limitations when calculating this figure. If your existing assets are challenging to convert into cash or if your business is highly seasonal, it might be worth it to look into alternative liquidity ratios.

Otherwise, use the current ratio as a way of identifying your ability to pay off your short-term obligations. The ratio itself is simple to calculate, and the number you are looking for would be one or higher to prove that you can pay off your financial obligations.

Grey Idol

Grey was previously the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helped businesses find the information they needed to make informed decisions about invoice factoring and A/R financing.

What Is the Current Ratio? | altLINE (2024)

FAQs

What Is the Current Ratio? | altLINE? ›

The current ratio, also known as the working capital ratio, evaluates a company's ability to pay short-term obligations. It does so by dividing current liabilities by current assets. The current ratio is an essential metric that every business owner should track routinely.

What does current ratio explain? ›

The current ratio measures a company's ability to pay current, or short-term, liabilities (debts and payables) with its current, or short-term, assets, such as cash, inventory, and receivables.

What is a good good current ratio? ›

A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts. A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term liabilities.

What does a current ratio of 1.5 mean? ›

For example, if a company has a current ratio of 1.5—meaning its current assets exceed its current liabilities by 50%—it is in a relatively good position to pay off short-term debt obligations. Conversely, if the company's ratio is 0.8 or less, it may not have enough liquidity to pay off its short-term obligations.

Is a higher current ratio better? ›

The higher the ratio is, the more capable you are of paying off your debts. If your current ratio is low, it means you will have a difficult time paying your immediate debts and liabilities. In general, a current ratio of 2 or higher is considered good, and anything lower than 2 is a cause for concern.

What does a current ratio of 1.0 mean? ›

The current ratio of 1.0x is right on the cusp of an acceptable value, since if the ratio dips below 1.0x, that means the company's current assets cannot cover its current liabilities. If the ratio were to drop below the 1.0x “floor”, raising external financing would become urgent.

What does a current ratio of 1.1 mean? ›

A 1.1 ratio means the company has enough cash to cover current liabilities. Figure 6.5 Cash is the most liquid asset a company has and is often used by investors and lenders to assess an organization's liquidity. (

What is a bad current ratio? ›

What is a bad current ratio? A current ratio below 1.0 suggests that a company's liabilities due in a year or less are greater than its assets. A low current ratio could indicate that the company may struggle to meet its short-term obligations.

Is a current ratio of 3 good or bad? ›

In general, a current ratio between 1.5 and 3 is considered healthy. Ratios lower than 1 usually indicate liquidity issues, while ratios over 3 can signal poor management of working capital.

Is a current ratio of 9 good? ›

For example, a current ratio of 9 or 10 may indicate that your company has problems managing capital allocation and is holding too much cash in its accounts. From a business perspective, that cash would be better spent on investments or growth initiatives.

Is a current ratio of 5 bad? ›

The current ratio measures a company's capacity to pay its short-term liabilities due in one year. The current ratio weighs a company's current assets against its current liabilities. A good current ratio is typically considered to be anywhere between 1.5 and 3.

Why is a 2 to 1 current ratio bad? ›

Short Answer. 2:1 current ratio shows the defensive style of business operation, low investment for growth and limited opportunity.

Is the current ratio of 4 good? ›

What is good current ratio? A healthy current ratio is normally between 1.5 and 2, but this can vary depending on the industry in which your company operates. A current ratio indicates whether a corporation has enough cash flow to cover its immediate debts and liabilities, if necessary.

How high is too high for current ratio? ›

A high ratio (greater than 2.0) indicates excessive current assets in the form of inventory, and underemployed capital. A low ratio (less than 1.0) indicates difficulty to meet short-term financial obligations, and the inability to take advantage of opportunities requiring quick cash.

Why is Walmart's current ratio so low? ›

Walmart has a current ratio of 0.83. It indicates that the company may have difficulty meeting its current obligations. Low values, however, do not indicate a critical problem. If Walmart has good long-term prospects, it may be able to borrow against those prospects to meet current obligations.

What is a healthy quick ratio? ›

What is a good quick ratio? When it comes to the quick ratio, generally the higher it is, the better. As a business, you should aim for a ratio that is greater than or equal to one. A ratio of 1 or more shows your company has enough liquid assets to meet its short-term obligations.

What does a current ratio of 0.8 mean? ›

A current ratio of 0.8 indicates a poor liquidity position of the company. The current assets of the company are not sufficient to meet its current liabilities. Also, the company is not efficiently managing its working capital.

What does a current ratio of 1.2 mean? ›

A current ratio of 1.2 indicates that the current assets are 1.2 times the current liabilities. The current assets are greater than the current liabilities, which indicates the good liquidity position of the company.

What does a current ratio of 2.5 times represent? ›

The current ratio for Company ABC is 2.5, which means that it has 2.5 times its liabilities in assets and can currently meet its financial obligations Any current ratio over 2 is considered 'good' by most accounts.

Is 1.3 in current ratio good? ›

"A current ratio of 1.2 to 1 or higher generally provides a cushion. A current ratio that is lower than the industry average may indicate a higher risk of distress or default," Fillo says. Some businesses may prefer an even higher current ratio, say 2 to 1 or 3 to 1.

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