Current Ratio Formula
The current ratio compares a company’s current assets to its current liabilities.
What is the Current Ratio?
The current ratio is one of many liquidity ratios that you can use to measure a company’s ability to meet its short-term debt obligations as they come due. The current ratio compares a company’s current assets to its current liabilities. Both of these are easily found on the company’s balance sheet, and it makes the current ratio one of the simplest liquidity ratios to calculate.
Current Ratio Formula and Breakdown of Components
The current ratio formula is:
Current Ratio = Current Assets / Current Liabilities
Current Assets
The current ratio is a liquidity ratio. Liquidity refers to how quickly a company can convert its assets into cash without affecting its value. Current assets are more highly liquid than long-term assets. Current assets are those that can be easily converted to cash, used in the course of business, or sold off in the near term –usually within a one year time frame. Current assets appear at the very top of the balance sheet under the asset header.
Current assets include:
- Cash & Cash equivalents
- Short-term investments
- Accounts receivable
- Inventory
Current Liabilities
Liabilities are obligations or debts owed by the company. Current liabilities are the payments that are due within the near term– usually within a one-year time frame.
Current liabilities include:
- Accounts payable
- Interest payable
- Salaries payable
- Taxes payable
The current portion of long-term liabilities are also carved out and presented with the rest of current liabilities. For example, let’s assume you have 12 payments due per year on your 30-year mortgage. The current 12 months’ payments are included as the current portion of long-term debt.
Current Ratio Limitations
The current ratio includes inventory and prepaid expenses in the total current assets calculation within the formula. Inventory and prepaid assets are not as highly liquid as other current assets because they cannot be quickly and easily converted into cash at a known value.
If you need to sell off inventory quickly in order to cover a debt obligation, you may have to discount the value considerably to move the inventory. Inventory sold at a discount does not have the same value as the inventory book value on the balance sheet. It is therefore a riskier current asset because the true value is somewhat unknown.
Prepaid assets are unlikely to be refunded to the company in order for it to meet current debt obligations. It is listed as a current asset because it is something you have paid for that provides a benefit to the company over the upcoming year, but it is unlikely to result in cash that can be used toward a debt obligation. Once you’ve prepaid something– like a one-year insurance premium– that money is spent.
What is a Good Current Ratio?
Typically, a 1.0 current ratio is considered to be acceptable as the company has enough current assets to cover its current liabilities. However, if most of that is tied up in inventory, a 1.0 current ratio may not be sufficient. A good current ratio may fall in the 1.5 to 2.0 range, depending on the industry. Having double the current assets necessary to pay current debt obligations should be seen as a good sign.
What is considered to be a good current ratio depends highly on the business type and industry. Since they are so variable, it only makes sense to compare similar sized companies in a similar industry if you are comparing two or more companies to each other. The current ratio can also be used to track trends within one company year-over-year.
Current Ratio Formula Real-World Example
To demonstrate the importance of only comparing current ratios within one industry, let’s examine the current ratios of three very different companies:
- Walmart, Inc., as of its fiscal year ending January 31, 2023
- Alphabet, Inc. (Google), as of its fiscal year ending December 31, 2022
- FedEx Corporation, as of its fiscal year ending May 31, 2023
Walmart has the lowest current ratio– with its current assets being less than its current liabilities. This is not a good sign for its ability to pay its current debt obligations as they are due. It is especially bad because Walmart is a major retailer with most of its current assets tied up in inventory. If you were to look at its quick ratio, it would be even lower– shown below for comparison’s sake.
Google has a sufficient amount of current assets to cover its current liabilities. At over 2.0, this would be considered a good current ratio in most industries.
FedEx has more current assets than current liabilities, and its current ratio is over 1.0. This is also an acceptable current ratio.
Current Ratio Formula vs Quick Ratio Formula
To combat the liquidity limitation of the current ratio, there is a more conservative liquidity formula that removes inventory and prepaid expenses from current assets before comparing them to current liabilities. The quick ratio uses only the most liquid assets for its comparison. The formula for the quick ratio is:
Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities
The quick ratio is slightly more complicated to calculate because of the extra steps in removing inventory and prepaid expenses, but it makes more sense to use the quick ratio when a company has significant inventory or prepaid expenses.
Quick Ratio Real-World Example
Let’s take a look at the quick ratio for comparison’s sake. When inventory and prepaid assets are removed from current assets before they are divided by current liabilities, Walmart’s quick ratio drops even lower than its current ratio. Most of its current assets are tied up in inventory. Since Walmart’s inventory is significant, it would make more sense to compare Walmart to other major retailers using the quick ratio rather than the current ratio.
Google and FedEx have very little in inventory or prepaid assets, so their quick ratios aren’t far off from their current ratios.
Additional Resources
If you found this article useful, consider checking out our Financial Accounting Essentials where you'll learn how to build a balance sheet, income statement, and cash flow statement from scratch based on a set of transactions. You'll also learn to find, read, and analyze the financial statements of real companies such as Microsoft and PepsiCo. Students who have taken this course have gone on to work at Barclays, Bloomberg, Goldman Sachs, EY, and many other prestigious companies. Get started now!
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