This is an advanced guide on how to calculate Current Ratio with detailed analysis, interpretation, and example. You will learn how to use this ratio's formula to draw a clearer picture of a company's liquidity.
Definition - What is The Current Ratio?
One of the mathematical formulas you can use to determine a company’s liquidity, or its ability to pay off its short-term debts, is the current ratio.
Unlike the quick ratio and the more narrowly focused cash coverage ratio that only consider easily "cashable", or quick assets, this ratio takes a broader view of liquidity by including such assets as inventory in its calculation.
By measuring all of a company’s current assets against its current liabilities, you can arrive at a figure that will indicate how likely that company is to have enough resources to support its debts over the next year.
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So what does current ratio mean?
As a general rule of thumb, a ratio value of 1:1 (or 1) is considered to be the bare minimum as an acceptable level of liquidity, since it means there would be no short-term assets left over if all short-term debts were paid off.
Ideally, a ratio of 2:1 (or 2) provides a more comfortable buffer.
Formula
This liquidity ratio can be arrived at by simply dividing a business’s current assets by its current liabilities, as in the following example:
Current Assets Ratio = Current Assets / Current Liabilities
This ratio is also known as the current assets ratio, and sometimes it's referred to as the working capital ratio.
When you examine a company’s balance sheet, you’ll notice that short-term assets and liabilities are generally reported separately from, and usually ahead of, long-term assets and liabilities.
This makes it easy to see which asset and liability figures should be included in the current ratio formula.
Read also: Inventory to Working Capital - Formula, Example & Analysis
Current Ratio Calculator
Example
Looking at an illustration of the formula above will give us a better appreciation for the information it can provide.
If you were considering Company B as a potential investment, one of the many pieces of information you would scrutinize is the company’s state of liquidity.
In other words, you would want to know if Company B is in a comfortable position in terms of being able to pay off its short-term debts.
When you examine Company B’s balance sheet, it may look like this:
- Cash = $75,000
- Accounts Receivable = $40,000
- Inventory = $25,000
- Stock Holdings = $10,000
- Current Liabilities = $200,000
When we plug the relevant figures into the above formula, we end up with this:
As you can see, the value of the current asset ratio in this case is less than 1, which is not a very inspiring result.
It would be difficult for you to have confidence in Company B’s ability to pay off its liabilities for the coming year, since its current debts outweigh its current assets.
Interpretation & Analysis
So now we're done with the calculation, let's dive into how to use this ratio to measure a company's liquidity.
So what is a good current ratio?
The higher a current asset ratio value is, the better, since it tells you that a company can more easily meet its debt repayments.
If an organization has a ratio of 2, it means it has twice as much in assets as it does in liabilities.
The last thing you want to see is a company having to sell its fixed or revenue-generating assets in order to support its current debt load.
When this happens, it usually means the company isn’t earning enough from its regular business operations to operate effectively.
It could also mean that the business may be generating income, but is having trouble collecting what it’s owed.
Cautions & Further Explanation
It’s important to keep in mind that the ratio value can be skewed if a company’s assets are inventory-heavy.
Because inventory is not as liquid as other types of assets, this situation wouldn’t truly reflect the company’s ability to pay off its debts in the short-term, if it suddenly became necessary to do so.
