What is the Current Ratio?

All of the information that is needed to calculate the current ratio is found on a company’s balance sheet which is one of the financial statements it is required to include as part of their quarterly, or annual, earnings report. Using the current assets and current liabilities found on the balance sheet an investor can begin to perform ratio analysis. A current ratio of 1 would indicate that a company had $1 in current assets for every $1 in current liability. This would indicate a company may have cash flow problems because they are not maintaining a sufficient profit margin. On the other hand, a company that has a current ratio that is too high (for example over 3) may be sitting on cash and not providing an efficient return on assets for shareholders.

Current ratios are a snapshot of a company’s overall financial picture and should be viewed as such. Investors should take caution to ensure that, if they are comparing companies, the companies are in the same industry and that they look back over several earnings reports to spot any trends in the movement of the current ratio.

Introduction

If you’ve ever known what it’s like to live “paycheck to paycheck” you know that it’s not fun and, in many cases, it’s not sustainable. You want to show more assets coming in than expenses going out. It’s the same for a healthy business. However, businesses can have different models for when assets come in and when expenses go out. And so, while they have to submit things like balance sheets and income statements, these require a bit more analysis by investors.

The current ratio is a form of ratio analysis that focuses on a company’s financial strength by measuring its ability to pay its current financial obligations (i.e. liabilities) with its current assets. Although this can be a useful starting point for investors, the current ratio should not be seen as a standalone metric.

In this article, we’ll define what the current ratio is, how to find current assets and liabilities, and how to interpret the ratio once it’s calculated. After that, we’ll review some limitations of the current ratio and define a few other ratios that can be used in conjunction with the current ratio to get a more holistic view of a company’s financial strength.

How to define assets and liabilities in the current ratio

Current assets are generally defined as an asset that can be converted to cash with relative ease within a short period of time (generally recognized as 12 months). Cash on hand and short-term investments would be considered the most obvious current assets. However, current assets can also include accounts receivable, which a company will be collecting in the short term, and inventory which can be sold for cash. Companies can also list marketable securities as current assets. Although they may not get a favorable price for these securities, they could be sold for cash if the need arose.

Current liabilities are generally defined as any amount a company owes to a third party (i.e. supplier or creditor) that will be due in the short term. Examples of current liabilities include accounts payable, any accrued expenses, income tax liability, short-term notes and whatever portion of long-term debt (e.g. loans) that are due within the time period involved. Again this is typically a 12-month time frame.

How to find a company’s current assets and liabilities

Public companies are required to provide periodic earnings reports, typically every quarter. One of the financial documents that they are required to submit as part of their earnings report is the balance sheet. Current assets and current liabilities are listed on the balance sheet. Assets are listed from top to bottom in order of their liquidity. So cash and cash equivalents will always be the top line followed by marketable securities, accounts receivable, inventory, and prepaid expenses.

A list of long-term assets might include items like long-term investments if a company knows they will not or cannot convert them to cash in the next year, fixed assets such as land, machinery, equipment or buildings, and intangible assets which are the most variable part of a balance sheet because it includes items that may have a more intrinsic value such as patents, trademarks, and other types of intellectual property. 

The liabilities on a balance sheet are a listing of money that a company owes. Like assets, liabilities are usually broken down into current and long-term liabilities. A sample list of current liabilities might include

1. Portion of long-term debt that must be repaid within one year – For example if a company took out a five-year, $10,000 loan. They might, for example, record $2,000 as a current liability and $8,000 as a future liability.
2. Money owed to any banks (referred to as bank indebtedness)
3. Interest payable
4. Payments for rent, taxes, and/or utilities
5. Wage expenses
6. Prepayments to customers
7. Scheduled dividend payments

A sample list of long-term liabilities might include:

1. Long-term debt – in our example above, the $8,000 would be listed here. This category also includes interest and principal on bonds issued.
2. Required payments into a company’s employee retirement accounts.
3. Accrued taxes that will not be paid for another year (also called deferred tax liability).

Here is what the balance sheet for L Brands showed for November 2018 (all figures in millions of USD).

For this balance sheet, the current ratio would be:

Current Assets (3,293)/Current Liabilities (2,031) = 1.62

How to interpret the current ratio

The simplest way to interpret the current ratio is like this. If a company’s current assets and current liabilities were exactly equal, their current ratio would be 1. That means that every dollar they were accounting for in current assets was being used up by current liabilities. As you can imagine then a number of 1 and certainly any number that is less than 1 is considered a bad sign by investors. It suggests that a company does not have sufficient liquidity to meet their obligations. However, companies that have a high current ratio (generally considered as above 3) may indicate that they are not using their assets as efficiently as they can. For example, they may be choosing not to secure financing that can help them grow or expand.

However, while a number higher than 1 is generally seen as a good sign, there are limitations to the current ratio that every investor should understand. To begin with, it is not a particularly helpful tool when comparing one company with another. This is particularly true if the companies are in different industries.  That’s because the business model between sectors may vary greatly. In some industries, it is common practice to extend credit to clients and/or customers for up to 90 days. This may lead to those companies as showing a current ratio that looks stronger because they would count the money that is due to them as a current asset, even though they do not have the cash at that time.

This brings to light another limitation of the current ratio. It is a snapshot of a company’s balance sheet that is not necessarily reflective of their actual cash flow. A company may show a low current ratio because of seasonal liabilities, but they still have a strong cash flow.

Yet another limitation of the current ratio is that, without careful scrutiny of the balance sheet, it can be very non-specific. As shown above, current assets can run a wide gamut as can current liabilities. The only way to know about the quality and liquidity of those assets is to look on the balance sheet. For example, if a company has a high amount of their current assets in inventory that may indicate they are overstocked or have inventory that is unwanted. Eventually, that can turn out to reduce the value of that company’s balance sheet. Likewise, two companies may show a similar amount of current liabilities, but they are weighted in different ways (i.e. one company may have a higher amount of accounts payable then another which has short-term notes that may or may not have to be paid at that moment in time).

A current ratio may change over time

One of the most important things an investor can look for in analyzing the current ratio is its performance over time. If a company’s current ratio is getting smaller (i.e. closer to 1 or below 1) over a period of several earnings periods or years, it may be an indication of solvency problems. They may be taking on too much debt or they may be burning through cash. Likewise, a company that is showing a current ratio that is growing may indicate that its cash position is getting stronger. But the direction is not the only thing to watch for. Investors should also pay attention to the volatility of the changes. In theory, unless there is some significant event in the business, the current ratio should be fairly stable. If there are big movements in one direction or another, it should be looked at closely and compared with other companies in the sector to see if the problem is isolated to that company or indicative of an industry-wide condition.

How to use the currency ratio with other ratios

Because the currency ratio has some limitations, investors can – and should – use other ratios to help get a better idea of what the current ratio is really saying about the health of a business. Some of the more common ratios are:

• Cash asset ratio – this is a ratio that only compares a company’s current liabilities to its current marketable securities and cash.
• Acid-test ratio (also known as quick ratio) – this is closest to the current ratio but excludes inventory and prepaid expenses from current assets.
• Operating cash flow ratio – this compares the active cash flow that a business receives from operations to its current liabilities.

The bottom line on current ratio

The current ratio is one, but only one, of several liquidity ratios that an investor can use to analyze the solvency of a business. Simply put, the currency ratio – along with other ratios such as the quick test (or acid-test) gives investors an idea of how easily a company could pay its bills and still meet debt obligations such as payroll. The current ratio is an indication of how a business can pay off the current liabilities listed on its balance sheet using the current assets available to them.

Although current ratio is one way to assess the financial strength of a business, it does have its limitations. One limitation is that is not an accurate comparison tool for comparing companies in two different industries. Also, because the current ratio is really a snapshot of a company’s solvency ratio at a moment in time, it needs to be looked at in line with its historical trend to get a better picture of the ability of a business to meet its financial obligations.