Current ratio is a measure of a company's liquidity, or its ability to pay its short-term obligations using its current assets. It's also a useful ratio for keeping tabs on an organization's overall financial health.
Here's what it is, how to calculate it, and how to interpret your results.
What is current ratio?
To understand your current ratio, you need to understand a couple of subtotals on your company's balance sheet.
- Current assets. Current assets are everything your company owns that you can reasonably expect to liquidate or turn into cash within one year. This normally includes cash and cash equivalents, prepaid expenses, accounts receivable, and inventory.
- Current liabilities. Current liabilities are obligations your company is expected to pay within one year. Examples of current liabilities include accounts payable, accrued expenses, and the portion of long-term debt due within the next 12 months.
Current ratio, also known as working capital ratio, shows a company's current assets in proportion to its current liabilities.
How to calculate current ratio
The formula for calculating current ratio is:
Current assets / current liabilities = current ratio
Dividing your total current assets by your total current liabilities determines how much of your current liabilities can be covered by your current assets.
For example, say your company's balance sheet shows the following current assets and current liabilities as of December 31, 2021:
- Cash: $150,000
- Accounts Receivable: $25,000
- Prepaid Expenses: $2,000
- Inventory: $75,000
- Total current assets: $252,000
- Accounts payable: $20,000
- Accrued expenses: $7,000
- Short-term debt: $15,000
- Total current liabilities: $42,000
So, your current ratio on December 31, 2021, would be:
$252,000 / $42,000 = 6
This means you could pay off your current liabilities with your current assets six times over.
What is a good current ratio?
Ideally, you want a current ratio greater than one. This signals that you're in a strong position to pay your current obligations without taking on more debt or needing a cash infusion from shareholders or investors.
A current ratio of less than one could indicate that your business has liquidity problems and may not be financially stable.
There is no one-size-fits-all definition of a too-high current ratio. It depends on your business and the industry in which you operate. However, an excessively high current ratio may indicate that a company is hoarding cash instead of investing it into growing the business. In most industries, a current ratio between 1.5 and 3 is considered healthy.
Current ratio limitations
While keeping an eye on your current ratio can be helpful, it's not the only metric for measuring your company's short-term liquidity. Some other useful ratios include:
Quick ratio is similar to the current ratio, but it does not include inventory in the numerator because inventory isn't always easily converted into cash.
(Current assets – inventory) / current liabilities = quick Ratio
Acid test ratio
The acid test ratio is a variation of the quick ratio, but it doesn't include inventory or prepaid expenses in the numerator.
(Current Assets – Prepaid Expenses – Inventory) / Current Liabilities = Acid Test Ratio
The debt-to-equity ratio divides total liabilities by total shareholder equity. This is a useful metric for comparing what a company owes (debt) to what it owns.
Total liabilities / total shareholder equity = debt-to-equity ratio
The cash ratio is the strictest measure of a company's liquidity because it only accounts for cash and cash equivalents in the numerator.
Cash and cash equivalents / current liabilities = cash ratio
Looking at any metric by itself or at a single point in time isn't a useful way to measure a company's financial health. Instead, it's important to consider other financial ratios in your analysis and look at those ratios over an extended period. This gives you a more accurate view of your company's liquidity and spot irregularities.