Current Ratio: Definition, Examples & Limitations

Current Ratio: Definition, Examples & Limitations

The current ratio can be used to compare different companies across the same industry, helping identify businesses that are more financially secure. However, it’s essential to consider industry norms, as the ideal current ratio can vary across industries. The current ratio measures how well a company can meet its short-term obligations. It is an important gauge of a company’s health and indicates how likely the company is to pay its bills. A current ratio calculated for a company whose sales are highly seasonal may not provide a true picture of the business’s liquidity depending on the time period selected. Small business owners should keep an eye on this ratio for their own company, and investors may find it useful to compare the current ratios of companies when considering which stocks to buy.

Formula For Current Ratio

Current assets are things the company owns that could be converted to cash in the next 12 months. You can calculate the current ratio by dividing a company’s total current assets by its total current liabilities. Again, current assets are resources that can quickly be converted into cash within a year or less, including cash, accounts receivable and inventories. The current ratio includes inventory and prepaid expenses in the total current assets calculation within the formula.

Why You Can Trust Finance Strategists

A ratio of over 1 indicates the numerator (current assets) is greater than the denominator (current liabilities). A company with a current ratio of greater than one has more assets than liabilities and therefore has the ability to pay off all their obligations if they were to come due suddenly over the next twelve months. For instance, a company with a current ratio of 1 does not have as many assets as accounting for asset exchanges a company with a ratio of 3, although both companies would be able to pay off their short-term obligations. In 2020, public listed companies reported having an average current ratio of 1.94, meaning they would be able to pay their debts 1.94 times over, if necessary. Typically, a 1.0 current ratio is considered to be acceptable as the company has enough current assets to cover its current liabilities.

Table of Contents

The current 12 months’ payments are included as the current portion of long-term debt. 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. The current ratio is a very common financial ratio to measure liquidity. What makes the current ratio “good” or “bad” often depends on how it is changing. A company that seems to have an acceptable current ratio could be trending towards a situation where it will struggle to pay its bills.

  1. A large retailer like Walmart may negotiate favorable terms with suppliers that allow it to keep inventory for longer periods and have generous payment terms or liabilities.
  2. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs.
  3. It’s one of the ways to measure the solvency and overall financial health of your company.
  4. Perhaps it is taking on too much debt or its cash balance is being depleted—either of which could be a solvency issue if it worsens.

Also, it isn’t easy to compare the current ratios of different companies because each company uses its own inventory valuation method. In the current ratio equation, current liabilities are found by summing up short-term notes payable + accounts payable + payroll liabilities + unearned revenue. As the assets and liabilities are listed in the descending order of liquidity, current assets would appear above non-current assets. GAAP  requires that companies separate current and long-term assets and liabilities on the balance sheet. This split allows investors and creditors to calculate important ratios like the current ratio.


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