Every company has a balance sheet that measures the financial health of the business. The most basic measurement is to simply track the incoming and outgoing cash. Sales and tax breaks generate income, but it can also come from selling off assets. Outgoings are spent on supplies, wages, unpaid taxes, debts, and other expenditures.
Companies use liquidity ratios or liquidity measures to include the value of assets in their balance sheets. Liquidity refers to the ease with which assets can be turned into cash. If there are debtors to be paid, then assets can be included in the balance books of the company, as well as cash, as they can also be used to pay off any short-term debt.
The current ratio is a liquidity measure that considers the value of all the different assets of a company against the total value of its short-term debts, also known as “obligations.”
We are going to take a look at the current ratio, what it means, how to calculate it, how to use it, and some of the alternative measurements that can be used in its place.
What is the current ratio?
Sometimes known as “the working capital ratio,” the current ratio measures whether a company can pay off its short-term obligations or those due within one year. The current ratio gets its name from the fact that it incorporates all the current assets of a company and all its current financial obligations.
A current ratio above one means that a company has the requisite assets to meet all its financial obligations. If a company has a current ratio of less than one, it does not have enough assets to pay off its obligations. However, as we will come to see, measuring the financial health of a company is not always as simple as this.
So let’s start by finding out how to calculate the current ratio using the current ratio formula.
How do you calculate the current ratio?
The current ratio can be calculated by dividing current assets by current obligations.
A company’s current assets include:
- company cash. This is all the cash a company has, either in hard form or in its bank accounts.
- the accounts receivable. This refers to money owed to a company for sales that have already been made but not yet fully paid for.
- the inventory. The inventory is made up of the goods for sale, including the raw materials owned by a company that will one day be for sale but that are yet to be manufactured.
- other current assets. This refers to anything of value that a company owns that can easily be turned into cash.
Current liabilities include:
- accounts payable. These are any short-term financial obligations that must be paid to a supplier or creditor and have not yet been paid.
- wages.
- unpaid taxes.
- short-term debts.
- long-term debts. Long-term debts are split into portions, so only the current portion being paid off should be included in the calculation.
Once you have calculated the value of your current assets and current liabilities, you simply do:
- Current assets / Current obligations = Current ratio
For example:
- A company has £100,000 in current assets and £75,000 in current liabilities
- 100,000 / 75,000 = 1.333
- The company’s current ratio is 1.333
What is a healthy current ratio?
The healthiness of a current ratio largely depends on the industry the company is in. However, as a general rule, a current ratio of 1.5 or more should have ample liquidity. A current ratio of 1.5 means the company would have £1.50 worth of current assets for £1 of liabilities.
A current ratio below 1 means that the company could well struggle with meeting its obligations. It would mean the company has less than £1 worth of current assets for every £1 of its obligations.
In 2020, the median ratio for publicly listed companies in the US was 1.94.
The current ratio at any time is only a snapshot of a company’s liquidity and can change quickly depending on the state of the market.
So, while a current ratio of less than one means that a company does not have the assets to meet its obligations and more than one means it does have enough, it is better to consider 1.5 as a more solid and stable benchmark as it allows for natural fluctuations within the ratio.
Is a low current ratio always bad?
A low current ratio doesn’t always spell disaster for a company.
For example, some large companies can negotiate long payment terms with their suppliers. This then shows the balance sheets to have very high obligations that have not been met yet by the sales revenue. However, the imbalance evens over time, leading to a more stable current ratio.
Many companies have a low current ratio at one time in the year but a much higher one at another date. Again, this shows that a low current ratio can just be part of the natural cycle of a business’s income and outgoings. Companies that sell seasonal goods or services are particularly liable to imbalanced current ratio measures.
Is a high current ratio always good?
Generally speaking, the higher the current ratio, the more able a company is to pay off its obligations.
However, a high current ratio could signify that a company is operating inefficiently and needs to work to better manage its assets and working capital.
So, while a high current ratio means that a company will be able to cover its obligations, it can also indicate weaknesses in other areas.
What are the advantages of measuring the current ratio?
The current ratio has many advantages as a liquidity measure. So let’s take a look at some of them:
- The current ratio indicates how stable and asset rich a company is in very simple terms. As we have seen, sometimes these terms can be too simple, but the current ratio offers a brief overview of the short-term financial stability of a company.
- The current ratio shows a company’s operating cycle and suggests how efficient it is in making sales and converting current assets into cash. Having an awareness of this allows companies to optimise production and the overhead costs of the business.
- The current ratio represents a company’s efficiency in meeting the demands of its creditors.
What are the disadvantages of measuring the current ratio?
There are also limitations to using the current ratio as a liquidity measure. For example:
- The current ratio takes the inventory into account, which can lead to overestimating the liquidity of a company. If a company has a large inventory, this may be due to low sales or an over-supply of a product rather than a healthy liquidity status.
- The current ratio also doesn’t take into account the time of year. Some companies have seasonal demand and sales, so it is hard to accurately measure over a long period by simply analysing the current ratio.
- The current ratio is easily manipulated to make a company appear more stable to potential investors.
- It is hard to accurately compare the current ratio of different companies with one another, especially across different industries.
What other liquidity ratios are there?
There are several other liquidity ratios that businesses use as well as or instead of the current ratio. Each has its advantages and disadvantages. With each measurement, the ratio can help businesses and their investors gain a better understanding of the current status of the company’s assets and liabilities.
So let’s take a look at some of the alternatives.
Acid-test ratio
Sometimes known as the “quick ratio,” the acid test ratio measures the ability of a company to use its easily liquidated assets (cash, amounts receivable, short-term investments) to cover all of its current liabilities.
It is similar to the current ratio, but it does not include certain assets that are harder to liquidate, such as the inventory.
Operating cash flow ratio
The operating cash flow ratio measures the number of times a company can pay its current obligations with the cash it makes in the same period.
This ratio only measures cash as the asset used to pay off debts rather than including multiple different assets.
Summary
The current ratio measures the value of a company’s assets against all of its short-term financial obligations. It is a liquidity ratio as it measures the ability of a company to turn its assets into cash in order to pay off any debts it has. To work out the current ratio, you simply divide the company’s current assets by its current obligations.
A current ratio of more than one means that a company can afford to pay its obligations; less than one means its assets do not cover the current obligations. However, the financial health of a company is not always simple to assess by looking solely at its current ratio. There is a range of liquidity measures, each with advantages and disadvantages. Using different liquidity measures should give you a broader picture of the health of a company. Still, the current ratio takes into account the total value of a company as it includes every liquifiable asset.