What Does Current Ratio Mean?

Table of Contents

1. What Is a Current Ratio?

2. How to Calculate the Current Ratio

3. Assets in the Current Ratio

4. Liabilities in the Current Ratio

5. What Are the Uses of Current Ratio

6. What Is a Good Current Ratio?

7. What Is a Bad Current Ratio

8. What Is the Difference Between the Current Ratio and the Quick Ratio?

9. Looking at the Current Ratio

The current ratio is an important metric because it shows a company’s capabilities to meet its short-term obligations based on its ability to liquidize to settle its debts. Here is everything you need to know about the current ratio and what it means for a business.

What Is a Current Ratio?

A current ratio is a type of liquidity ratio (including acid-test ratio and quick ratio). The current ratio measures the real-time financial health of a business. Finance professionals and accountants calculate the current ratio by comparing the current assets of a company to the current liabilities of a company. It is sometimes also called a working capital ratio.

When calculating the current ratio, a finance professional will only consider assets and liabilities that will be used up or due in the period of 1 year.

Often, business attorneys advise clients to carefully examine the current ratio of a potential acquisition target to ensure it has a healthy balance of assets to liabilities before proceeding with any legal transactions.

How to Calculate the Current Ratio

Calculate the current ratio of a business by using the following formula:

Current assets are divided by current liabilities.

Remember, current assets are assets that could be liquified within 1 year. Current liabilities are debts that are due within 1 year.

Assets in the Current Ratio

Current assets that are calculated in the current ratio may include:

Accounts receivable
Cash
Cash equivalents
Inventory
Marketable securities
Notes receivable
Other current assets (like real estate, equipment, etc., that might be liquidated to pay debt.)
Prepaid expenses

Liabilities in the Current Ratio

Current liabilities that are calculated in the current ratio may include:

Accounts payable
Accrued expenses
Term debt
Deferred revenue
Notes payable
Other current liabilities

Only liabilities that are due to be paid within 1 year will be used in current ratio calculations.

What Are the Uses of Current Ratio

There are uses for the current ratio both internally and externally.

Internal

The current ratio is used internally to take the temperature of the business’s financial well-being. It is also calculated for the financial statements of the business.

External

Externally, the current ratio will be considered by lenders to see if the company will be able to pay off the debt considering its current asset-to-debt ratio. Investors will often use the current ratio to see if the company is a good financial investment.

What Is a Good Current Ratio?

The current ratio is the number of times the business can pay off its liabilities using its assets, so you want a high number. The higher the current ratio is, the more assets a company has compared to its liabilities.

What is considered a good current ratio will be dependent on the industry the company is in. Different industries have different averages because of their unique needs and business models. The relation of the person considering the current ratio will also impact what they would consider a good current ratio.

A current ratio is considered good if it is between 1 and 3. An investor or lender may consider higher current ratios to be better as it shows good financial stability. A business owner may not want a current ratio that is too high, as that may indicate that the business could better leverage its assets to invest into growth.

What Is a Bad Current Ratio

If a business has a current ratio of less than 1, that does not necessarily mean the company is not financially secure. One of the limitations of the current ratio is that inventory is calculated as a current asset at the cost of purchase. Companies sell inventory for more than the cost of purchase, so companies that need to purchase inventory upfront may have a lower current ratio.

In general, a current ratio is considered bad if it is below 1 or above 3, as low and high current ratios could indicate problems. As stated above, there are a lot of factors that may impact what is considered a good or bad current ratio. The industry of the company will often impact the average current ratio and what is considered good or bad.

What Is the Difference Between the Current Ratio and the Quick Ratio?

Both are liquidity ratios that measure the company’s ability to pay for its debts. Here is how a quick ratio is different from a current ratio:

Inventory: Prepaid expenses and inventory are not counted as liquid assets as they cannot be accessed immediately to cover debts.
Evaluation: The quick ratio is considered a more conservative measure than the current ratio. A company that has a lot of inventory will have a lower result when it uses the quick ratio to calculate financial stability as opposed to the current ratio.

Looking at the Current Ratio

The current ratio is an important financial metric, but it is just one metric. It gives you a good indication of the company’s ability to pay off short-term debt and retain a good credit rating. However, it does not give a good insight into the overall health of the company.

If you are looking at a company’s current ratio as an investor, you should also look at:

Historical performance: This will give you context for the current ratio. For example, you might notice that there are short-term issues affecting the financial health of the company. Or you might notice that the company is experiencing growth and is successful regardless of the low current ratio.
Competitor current ratios: The current ratio works best as a comparison between two or more companies. Comparing current ratios allows you to see the industry average. Some industries or business models tend to have lower current ratios.
Historical current ratio: Look at the company’s past, current ratios to see if it has been trending upwards or downwards. There are many reasons why a current ratio would increase or decrease, but it should increase overall when you look at long-term trends.

As an investor, you should not be looking at the current ratio alone. Make sure you get a wide spread of financial metrics so you can make informed investment decisions. Compare financial metrics between companies in similar fields so you can understand performance against industry averages.

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