Learning how to calculate the current ratio can give you an excellent insight into your firm’s short-term liquidity. That’s important, because if you don’t have a good grasp of the solvency of your business, you won’t be able to maintain an accurate picture of your company’s financial health. Find out more about the current ratio with our comprehensive guide. Firstly, what is the current ratio? Show
Current ratio definitionThe current ratio, sometimes referred to as the working capital ratio, is a liquidity ratio that you can use to determine whether the assets that you’re holding (which can be converted to cash within a year) are enough to pay off your current liabilities (that must be paid off within a year). In other words, it’s a financial metric you can use to evaluate your ability to pay your short-term obligations. There are several other liquidity ratios that you may encounter when researching the current ratio, but it’s important to remember that these ratios measure slightly different things. The quick ratio is used to determine whether your company’s quick assets (assets that are convertible to cash within 90 days) are enough to pay off your current liabilities. The cash ratio looks solely at cash and cash equivalents. Now that you know a little more about the current ratio and what it means for your business, let’s explore how to calculate the current ratio. How to calculate the current ratioYou can calculate the current ratio using the following current ratio formula:
This is a relatively simple equation, so let’s break it down. Current assets refer to assets that can reasonably be converted to cash within a year. This means accounts receivable, inventory, prepaid expenses, marketable securities, cash, and cash equivalents. Current liabilities are short-term financial obligations, including accounts payable, short-term debt, interest on outstanding debt, taxes owed within the next year, dividends payable, etc. You should be able to find your business’s current assets and current liabilities on the balance sheet. What is a good current ratio?To a certain degree, whether your business has a “good” current ratio is determined by industry type. However, in most cases, a current ratio between 1.5 and 3 is considered acceptable. Some investors or creditors may look for a slightly higher figure. By contrast, a current ratio of less than 1 may indicate that your business has liquidity problems and may not be financially stable. However, you should remember that a higher current ratio doesn’t always mean that your business is in a healthier financial position. 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. Limitations of the current ratio formulaAlthough the current ratio can be immensely helpful, there’s one clear limitation. When you calculate the current ratio, you’ll need to include relatively illiquid assets (assets that can’t easily be converted into cash) such as inventory or accounts receivable. As such, the current ratio formula may not be the best metric to use for determining your business’s short-term liquidity. Besides, the current ratio may not give you an accurate picture of your business’s liquidity if you’re a seasonal business, as assets/liabilities are likely to vary wildly depending on the period selected. As such, you should look at the current ratio over a more extended period to get a more accurate sense of your accounting liquidity and the proportion of your current assets to liabilities. We can helpGoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments. Current Assets / Current Liabilities The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-term obligations that are due within a year. The ratio considers the weight of total current assets versus total current liabilities. It indicates the financial health of a company and how it can maximize the liquidity of its current assets to settle debt and payables. The current ratio formula (below) can be used to easily measure a company’s liquidity.  Image: CFI’s Financial Analysis Fundamentals Course The Current Ratio formula is: Current Ratio = Current Assets / Current Liabilities Example of the Current Ratio FormulaIf a business holds:
Current assets = 15 + 20 + 25 = 60 million Current liabilities = 15 + 15 = 30 million Current ratio = 60 million / 30 million = 2.0x The business currently has a current ratio of 2, meaning it can easily settle each dollar on loan or accounts payable twice. A rate of more than 1 suggests financial well-being for the company. There is no upper-end on what is “too much,” as it can be very dependent on the industry, however, a very high current ratio may indicate that a company is leaving excess cash unused rather than investing in growing its business. Download the Free Current Ratio Formula TemplateEnter your name and email in the form below and download the free template now! You can browse All Free Excel Templates to find more ways to help your financial analysis.
Current Ratio Formula – What are Current Assets?Current assets are resources that can quickly be converted into cash within a year’s time or less. They include the following:
Current Ratio Formula – What are Current Liabilities?Current liabilities are business obligations owed to suppliers and creditors, and other payments that are due within a year’s time. This includes:
Why Use the Current Ratio Formula?This current ratio is classed with several other financial metrics known as liquidity ratios. These ratios all assess the operations of a company in terms of how financially solid the company is in relation to its outstanding debt. Knowing the current ratio is vital in decision-making for investors, creditors, and suppliers of a company. The current ratio is an important tool in assessing the viability of their business interest. Other important liquidity ratios include:
Below is a video explanation of how to calculate the current ratio and why it matters when performing an analysis of financial statements. Video: CFI’s Financial Analysis Courses Additional ResourcesThank you for reading this guide to understanding the Current Ratio Formula. To keep educating yourself and advancing your finance career, these CFI resources will be helpful:
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Which of the following current ratios means the company is most able to pay its liabilities with current assets?
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