Current Ratio

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Current Ratio

Definition

The current ratio measures a company’s ability to meet short-term obligations. It compares all current assets to all current liabilities to show whether the business has enough resources to pay debts and bills due within one year.

Formula

Current Ratio = Current Assets / Current Liabilities

Current assets typically include:
* Cash and cash equivalents
* Accounts receivable
* Inventory
* Other assets expected to convert to cash within 12 months

Current liabilities typically include:
* Accounts payable
* Short-term debt and the current portion of long-term debt
* Wages payable, taxes payable, and other obligations due within 12 months

How it works and why it matters

A current ratio greater than 1.0 means current assets exceed current liabilities and the company is generally able to cover short-term obligations. Ratios below 1.0 suggest potential difficulty meeting short-term liabilities if all came due at once.

Because it uses balance-sheet values at a single point in time, the current ratio is a snapshot — useful but incomplete. It should be interpreted alongside trends, industry norms, and other liquidity measures to understand asset quality and timing (for example, whether receivables are collectible or inventory is salable).

Example

If a company has:
* Current assets = $500,000
* Current liabilities = $250,000

Current Ratio = $500,000 / $250,000 = 2.0

This indicates $2.00 of current assets for every $1.00 of current liabilities — generally a comfortable short-term position. However, if most assets are slow-moving inventory or uncollectible receivables, the apparent liquidity may be overstated.

Interpreting results

“Good” values vary by industry. Retailers, manufacturers, and service firms have different working-capital needs; always compare to peers and the company’s historical trend.

Using the ratio effectively

  • Compare the ratio over time to detect improving or deteriorating liquidity.
  • Benchmark against industry peers and competitors.
  • Inspect the composition of current assets (cash vs. receivables vs. inventory) and the timing of liabilities.
  • Combine with other measures for a fuller picture (see next section).

Related liquidity measures

  • Quick (acid-test) ratio — excludes inventory and prepaid items to measure easily liquidated assets.
  • Cash ratio — compares only cash and marketable securities to current liabilities.
  • Days Sales Outstanding (DSO) — measures how long it takes to collect receivables.
  • Operating cash flow ratio — compares cash generated by operations to current liabilities.

Limitations

  • Snapshot only — doesn’t show timing of receipts and payments.
  • Includes illiquid items — inventory and some receivables may not convert to cash quickly or at full value.
  • Industry differences — working-capital norms vary widely, making cross-industry comparisons misleading.
  • No insight into asset quality — aged receivables or obsolete inventory can overstate liquidity.

FAQs

Q: What if the current ratio is less than 1.0?
A: It suggests the company may not have enough short-term assets to cover all short-term liabilities and could face liquidity pressure, though timing and cash flows determine actual risk.

Q: What does a current ratio of 1.5 mean?
A: The company has $1.50 of current assets for every $1.00 of current liabilities — generally considered comfortable liquidity, subject to industry context and asset quality.

Q: How is the current ratio calculated?
A: Divide total current assets by total current liabilities, using values from the company’s balance sheet.

Bottom line

The current ratio is a straightforward indicator of short-term solvency that helps assess whether a company can cover obligations due within a year. Use it as an initial screen, then analyze trends, asset composition, industry norms, and complementary liquidity metrics to form a complete view of financial health.