All businesses have bills to pay. Your ability to pay them is called “liquidity,” and liquidity is one of the first things that accountants and investors will look at when assessing the health of your business.
The current ratio (also known as the current asset ratio, the current liquidity ratio or the working capital ratio) is a financial analysis tool used to figure out how liquid a business is. It takes all of your company’s current assets, compares them to your short-term liabilities, and tells you whether you have enough of the former to pay for the latter.
In other words, the current ratio lets you know whether you have enough cash to cover all of your pressing debt obligations.
Here, we’ll go over how to calculate the current ratio and how it compares to some other financial ratios.
How do you calculate the current ratio?
You calculate your business’ overall current ratio by dividing your current assets by your current liabilities.
Current assets (also called short-term assets) are cash or any other kind of asset that will be converted to cash within one year. You can find them on the balance sheet, alongside all of your business’ other assets.
The four major types of current assets are:
Cash equivalents, which include cash and short-term securities that your business can quickly sell off and convert into cash, like treasury bills, short-term government bonds and money market funds.
Marketable securities, which typically have a maturity period of one year or less, are bought and sold on a public stock exchange, and can usually be sold within three months on the market. Examples include common stock, treasury bills and commercial paper.
Accounts receivable, which is money your customers owe you for any products or services you delivered and invoiced them for.
Inventory, which is all the goods and materials a business has stored away for future use, like raw materials, unfinished parts, and unsold stock on shelves.
Your current liabilities (also called short-term obligations) are any outstanding bill payments, taxes, short-term loans or any other kind of short-term liability that your business must pay back within the next 12 months. You can find them on your business’ balance sheet, alongside all of your other liabilities.
Current liabilities do not include long-term debt, like bonds, lease obligations, long term notes payable, etc. Common examples include:
- Credit card debt
- Notes payable that mature within one year
- Wages payable
- Accounts payable
- Accrued liabilities like dividend, income tax, and payroll
What is the current ratio formula?
You calculate the current ratio by dividing your company’s current assets by your current liabilities, i.e.:
Current ratio = current assets / current liabilities
Let’s imagine that your fictional company, XYZ Inc., has $15,000 in current assets and $22,000 in current liabilities. Its current ratio would be:
Current ratio = $15,000 / $22,000 = 0.68
That means that the current ratio for your business would be 0.68.
A company with a current ratio of less than one doesn’t have enough current assets to cover its current liabilities. If your current ratio is 0.68, you might have liquidity problems.
But that’s also not always the case.
A low current ratio could also just mean that you’re in an industry where it’s normal for companies to collect payments from customers quickly, but take a long time to pay their suppliers, like the retail and food industries.
Or it could mean that your company is very good at keeping inventory low. (Remember: inventory is included in current assets.)
Current vs quick ratio
The quick ratio (also sometimes called the acid-test ratio) is a more conservative version of the current ratio.
The quick ratio differs from the current ratio in that it leaves inventory out and keeps the three other major types of current assets: cash equivalents, marketable securities and accounts receivable.
So the equation for the quick ratio is:
Quick ratio = (cash equivalents + marketable securities + accounts receivable) / current liabilities
Because inventory levels vary a lot across industries, this ratio should in theory give us a better reading of a company’s liquidity than the current ratio. But it’s important to put it in context.
A lower quick ratio could mean that you’re having liquidity problems, but it could just as easily mean that you’re good at collecting accounts receivable quickly. Similarly, a higher quick ratio doesn’t automatically mean you’re liquid, especially if you run into any unexpected problems collecting receivables.
Current vs cash ratio
An even purer (in theory) liquidity test is the cash ratio. This one takes accounts receivable out of the equation, leaving you with only cash equivalents and marketable securities to cover your current liabilities:
Cash ratio = (cash equivalents + marketable securities) / current liabilities
If you have a high cash ratio, you’re sitting pretty. It’s the most conservative measure of liquidity, and therefore the most reliable, industry-neutral method of calculating it.
Financial analysts will often also use two other ratios to calculate the liquidity of a business: the current cash debt coverage ratio and the cash conversion cycle (CCC).
The current cash debt coverage ratio is an advanced liquidity ratio that measures how capable a business is of paying its current liabilities using cash generated by its operating activities (i.e. money your business brings in from its ongoing, regular business activities).
The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales.