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About Wall Street Prep
What is the Current Ratio?
The Current Ratio is a measure of a company’s near-term liquidity position, or more specifically, the short-term obligations coming due within one year.
Often used alongside the quick ratio, the current ratio measures if a company can meet its short-term obligations using its short-term assets on the present date.
- What does the current ratio measure?
- How is the current ratio different from the quick ratio?
- As a general rule, what is the “target” current ratio for companies?
- Which types of companies tend to have lower (and higher) current ratios?
Table of Contents
How to Calculate the Current Ratio
A current ratio is categorized as a liquidity ratio since it assesses how financially sound the company is in relation to its near-term liabilities.
Liquidity ratios, like the current ratio, focus on the short-term — hence, the two main inputs are current assets and current liabilities.
The current ratio reflects a company’s capacity to pay off all its short-term obligations, under the hypothetical scenario that short-term obligations are due right now.
Additionally, the current ratio tends to be a useful proxy for how efficient the company is at managing its working capital.
Current Ratio Formula
The current ratio compares a company’s current assets to its current liabilities, so to calculate the current ratio, the required inputs can be found on the balance sheet.
Current Ratio Formula
- Current Ratio = Current Assets / Current Liabilities
- Current Assets: Cash & Equivalents, Marketable Securities, Accounts Receivable (A/R), Inventory
- Current Liabilities: Accounts Payable (A/P), Short-Term Debt
Simple Calculation Example
As a quick example calculation, let’s say a company has the following balance sheet data:
Current Assets
- Cash = $25 million
- Marketable Securities = $20 million
- Accounts Receivable (A/R) = $10 milliom
- Inventory = $60 million
Current Liabilities
- Accounts Payables = $55 million
- Short-Term Debt = $60 million
With that said, the required inputs can be calculated using the following formulas.
- Current Assets = $25 million + $20 million + $10 million + $60 million = $115 million
- Current Liabilities = $55 million + $60 million = $115 million
For the last step, we’ll divide the current assets by the current liabilities.
- Current Ratio = $115 million ÷ $115 million = 1.0x
Here, the current ratio of 1.0x is right on the cusp of an acceptable value — since if the current ratio dips below 1.0x, that means the company’s current assets cannot cover its current liabilities.
If the current ratio were to drop below the 1.0x “floor”, raising external financing would become urgent.
Interpreting the Current Ratio
The range used to gauge the financial health of a company using the current ratio metric varies on the specific industry.
For instance, supermarket retailers typically have low current ratios considering their business model (and free cash flows) are essentially a function of their ability to raise more debt to fund asset purchases (i.e. increases debt on B/S), as well as pushing back supplier/vendor payments (i.e. increasing accounts payable)
As a general rule of thumb, a current ratio in the range of 1.5 to 3.0 is considered healthy.
- High Current Ratio (1.5x to 3.0x): Company has sufficient current assets to pay off its current liabilities
- Low Current Ratio (<1.0x): Company has insufficient current assets to pay off its current liabilities
However, a current ratio <1.0 could be a sign of underlying liquidity problems, which increases the risk to the company (and lenders if applicable).
Tracking the current ratio can be viewed as “worst-case” scenario planning (i.e. liquidation scenario) — albeit, the company’s business model may just require fewer current assets and comparatively more current liabilities.
Here, the company could withstand a liquidity shortfall if providers of debt financing see the core operations are intact and still capable of generating consistent cash flows at high margins.
But a higher current ratio is NOT necessarily always a positive sign — instead, a current ratio in excess of 3.0x can result from a company accumulating current assets on its balance sheet (e.g. cannot sell inventory to customers).
While under a liquidation scenario, a higher amount of asset collateral is perceived positively, most companies focus on forward-looking performance like free cash flow (FCF) generation and profit margins, although everything is linked towards one another in some ways.
Drawbacks to the Current Ratio
One shortcoming of the current ratio is that the cash balance includes the minimum cash amount required for working capital needs.
Without the minimum cash on hand for operations to continue, as usual, the business cannot continue to run if its cash were to dip below this level — e.g. the company is struggling to collect owed cash payments from customers that paid on credit.
Likewise, the cash balance could contain restricted cash, which is not freely available for use by the business and is instead held for a specific purpose.
Next, the inclusion of short-term investments that cannot be liquidated in the markets easily could also have been included — i.e. low liquidity and cannot sell without selling at a loss at a substantial discount.
The last drawback to the current ratio that we’ll discuss is the accounts receivable amount can include “bad A/R”, which is uncollectable customer payments, but management refuses to recognize it as such.
Current Ratio vs Quick Ratio
Another common liquidity measure is the quick ratio, otherwise known as the “acid-test” ratio.
Compared to the current ratio, the quick ratio is considered a more strict variation due to filtering out current assets that are not actually liquid — i.e. cannot be sold for cash immediately.
By adjusting the numerator to include solely highly liquid assets that can truly be converted into cash in <90 days with a high degree of certainty, the quick ratio is a more conservative measure of liquidity.
Current Ratio Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Current Ratio Example Calculation
In our current ratio modeling exercise, we’ll be analyzing the change in the current ratio to see the underlying drivers at play.
As of Year 1, our hypothetical company has the following financials:
Balance Sheet Assumptions
Current Assets
- Cash & Equivalents: $20m
- Marketable Securities: $15m
- Accounts Receivable (A/R): $25m
- Inventory: $65m
Current Liabilities
- Accounts Payable: $45m
- Short-Term Debt: $80m
Putting the above together, the total current assets and total current liabilities each add up to $125m, so the current ratio is 1.0x as expected.
The company has just enough current assets to pay off its liabilities on its balance sheet.
As for the projection period — from Year 2 to Year 4 — we’ll use a step function for each B/S line item, with the Year 1 figures serving as the starting point.
Changes in Working Capital
Current Assets
- Cash & Equivalents: +$5m/Year
- Marketable Securities: +$5m/Year
- Accounts Receivable (A/R): +$3m/Year
- Inventory: +$2m/Year
Current Liabilities
- Accounts Payable: –$3m/Year
- Short-Term Debt: –$2m/Year
Clearly, the company’s operations are becoming more efficient, as implied by the increasing cash balance and marketable securities (i.e. highly liquid, short-term investments), accounts receivable, and inventory.
From Year 1 to Year 4, the current ratio increases from 1.0x to 1.5x, as the screenshot of our completed model output shows.
Note the growing A/R balance and inventory balance require further diligence, as the A/R growth could be from the inability to collect cash payments from credit sales.
The increase in inventory could stem from reduced customer demand, which directly causes the inventory on hand to increase — which can be good for raising debt financing (i.e. more collateral), but a potential red flag.
Therefore, applicable to all measures of liquidity, solvency, and default risk, further diligence is necessary to understand the actual financial health of a company.
