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 determine the short-term liquidity of a business. 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 is a good indicator of your company’s ability to cover all of your pressing debt obligations with the cash and short-term assets you have on hand. It’s one of the ways to measure the solvency and overall financial health of your company.
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’s overall current ratio by dividing your current assets by your current liabilities.
To do this, you’ll need to get familiar with your balance sheet—as one of the three primary financial statements your business produces, your balance sheet helps you get a sense of the big picture and serves as a historical record of a specific moment in time.
Current assets (also called short-term assets) are cash or any other asset that will be converted to cash within one year. You can find them on the balance sheet, alongside all of your business’s other assets.
The five major types of current assets are:
Cash and cash equivalents. These include cash and short-term securities that your business can quickly sell and convert into cash, like treasury bills, short-term government bonds, and money market funds.
Marketable securities. These 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. This account is used to keep track of any money customers owe for products or services already delivered and invoiced for.
Inventory. This includes all the goods and materials a business has stored for future use, like raw materials, unfinished parts, and unsold stock on shelves.
Prepaid expenses. These are future expenses that have been paid in advance that haven’t yet been used up or expired. Generally, prepaid expenses that will be used up within one year are initially reported on the balance sheet as a current asset. As the amount expires, the current asset is reduced and the amount of the reduction is reported as an expense on the income statement.
Your current liabilities (also called short-term obligations or short-term debt) are:
- Any outstanding bill payments
- Short-term loans
- Any other kind of short-term liability that your business must pay back within the next 12 months
You can find them on your company’s balance sheet, alongside all of your other liabilities.
Current liabilities do not include long-term debt, like bonds, lease obligations, and long-term notes payable.
Here are a few common examples of current liabilities:
- Credit card debt
- Notes payable that mature within one year
- Wages payable
- Deferred revenue
- Accounts payable
- Accrued liabilities (also known as accrued expenses) 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.:
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:
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 financial obligations. XYZ Inc.’s current ratio is 0.68, which may indicate 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.)
A high current ratio, on the other hand, may indicate inefficient use of assets, or a company that’s hanging on to excess cash instead of reinvesting it in growing the business.
What is a good current ratio?
As with many other financial metrics, the ideal current ratio will vary depending on the industry, operating model, and business processes of the company in question.
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.
The definition of a “good” current ratio also depends on who’s asking. In many cases, lenders prefer high current ratios, since it indicates that the company won’t have any issues paying the creditor back, while investors may take a high current ratio as a signal of operational inefficiencies.
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:
Because inventory levels vary widely across industries, in theory, this ratio should 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 encounter unexpected problems collecting receivables
Current vs. cash ratio
Looking for an even purer (in theory) liquidity test? You want the cash ratio.
The cash ratio takes accounts receivable out of the equation, leaving you with only cash equivalents and marketable securities to cover your 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. It measures how capable a business is of paying its current liabilities using the 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 (in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales.