What Is the Current Ratio?

Last Updated July 9, 2024

There are few more important financial metrics for business owners than the three liquidity ratios: the quick ratio, cash ratio, and current ratio.

Studies show that 50% of small businesses have fewer than 15 cash buffer days, a worrying statistic given these businesses are at great risk of failing if financial challenges are to arise. For small business owners in particular, knowing how to unlock liquidity can be crucial in keeping operations afloat when cash flow or lack of sales are dragging your finances below the surface.

Improving liquidity can be achieved by routinely calculating these three ratios, identifying what might be preventing the ratios from being an even healthier number, and implementing changes to operations as necessary.

This article is going to breakdown the most commonly calculated of three liquidity ratios: the current ratio. Continue reading to learn the current ratio formula, how to calculate it, what it reveals about a company, and the limitations with this ratio that should be taken into account.

What Is the Current Ratio?

The current ratio, also known as the working capital ratio, evaluates a company’s ability to pay short-term obligations. It does so by dividing current liabilities by current assets.

The current ratio is an essential metric that every business owner should track routinely. Not only is it important for business owners, but investors look at a company’s ratio when weighing investment opportunities.

What Is a Short-Term Obligation?

When looking at the current ratio, a company’s short-term obligation refers to any company’s payments within one year.

The current ratio compares assets within a company that can be converted to cash within a year to the liabilities it is also responsible for paying off within a year, ultimately determining how much working capital a business needs.

There are a few different liquidity ratios, the current ratio being one of them, that measure a company’s capacity to use its cash to meet the short-term financial needs. Other examples of liquidity ratios include:

• Quick Ratio
• Cash Ratio

How Do You Calculate the Current Ratio?

You can calculate the current ratio of any company by dividing its existing assets by its current liabilities. The number that the current ratio formula produces is equivalent to the number of times your company can pay its current financial obligations with its available assets.

Current Ratio Formula

The formula for current ratio is as follows:

Current Ratio = Current Assets / Current Liabilities

The higher the number produced from the formula, the more easily a company can pay its current financial obligations with its available assets, signaling stronger financial positioning.

Current Assets

According to the balance sheet of a company, there are multiple different current assets. Current assets include:

• Cash
• Cash equivalents
• Accounts receivable
• Inventory

Cash equivalents, which are considered a current asset, are different types of investments that will mature in less than three months and convert easily to cash. Examples of cash equivalents include:

• Government bonds
• Commercial paper
• Money market funds

Accounts receivable refers to the money that another company owes the primary company, while inventory includes the complete product within a company and the material used to create it.

Current Liabilities

On the other side of the ratio is current liabilities, which include:

• Accounts payable
• Income taxes payable
• Wages payable
• Dividends declared

Accounts payable is the existing amount a company owes to suppliers at any given time. Income taxes are the taxes a company owes to the federal government, much like individual income taxes. Wages payable includes any wages that have been earned by employees but not yet paid by the company. Dividends declared are approved and declared by the company’s board of directors but have not yet been paid are known as dividends declared.

How Does the Current Ratio Work?

A higher current ratio in a company typically means no short-term liquidity concerns, which is a good thing for small business owners. A good current ratio for a company is considered between 1.5-2.0 and higher, which indicates a comfortable financial position.

As a rule of thumb, investors don’t want to see a ratio below 1.0. This would indicate that the company might run out of money within the year or even sooner. However, if the company can increase cash flow or obtain additional investment capital, they might have the ability to sustain longer.

Keep in mind that acceptable ratios tend to vary amongst different industries. If you are dealing with industrial companies, a 1.2-1.5 may be adequate.

Despite a higher ratio indicating increased financial health, some investors might actually be wary of current ratios that are too high. This could signal a business that is hoarding cash and not paying off dividends or reinvesting money.

What Are the Limitations of the Current Ratio?

There are limitations when calculating the current ratio of a business. It is essential to look at each of them when determining whether it is a useful metric for your company.

1. Cash Conversion of Current Assets

One of the limitations involves accounts receivable and inventory. Because both current assets are not easily converted into cash, it is difficult to accurately determine a company’s short-term liquidity.

Cash Ratio

Instead of using current assets, the cash ratio looks at cash and cash equivalents only. Because these are the most liquid assets within a company, it can eliminate some of the limitations found when using the current ratio.

2. Business Seasonality

Additionally, for highly seasonal companies, the current ratio might not accurately depict the company’s liquidity.

3. Comparing Business to Business

Another limitation found in using the current ratio occurs when comparing businesses. Because there can be substantial differences amongst companies across different industries, it can become difficult to compare two against each other via the current ratio.

How Do You Calculate the Current Ratio in Excel?

There are multiple different Excel templates out there that will quickly help you keep track of your assets and liabilities. These templates will quickly calculate your current ratio at any given time, depending on the amount of information you provide.

An alternative way to calculate your ratio in Excel would be to use the simple division formula. Place your current assets total in one cell, your current liabilities in another, and calculate the current ratio in another cell.

Ex: Current assets in cell A1, current liabilities in cell A2. In cell A3, type “=A1/A2” and hit [return] to calculate. The number in A3 will be your current ratio.

In-Summary: What Is the Current Ratio?

While the current ratio is a helpful metric for small business owners and investors, it is crucial to understand some limitations when calculating this figure. If your existing assets are challenging to convert into cash or if your business is highly seasonal, it might be worth it to look into alternative liquidity ratios.

Otherwise, use the current ratio as a way of identifying your ability to pay off your short-term obligations. The ratio itself is simple to calculate, and the number you are looking for would be one or higher to prove that you can pay off your financial obligations.

Current Ratio FAQs

What is a good current ratio?

A good current ratio is considered 1.5 and above, though ratios between 1.2 and 1.5 can still be adequate for businesses in certain industries, such as industrial companies. On the other hand, if a company’s ratio is 1.0 or lower, that signals financial distress requiring immediate attention.

What does current ratio measure?

A company’s current ratio measures its liquidity, or ability to pay off short-term debt, by taking current liabilities and dividing them by current assets.

What is the difference between working capital and current ratio?

The lone difference between working capital vs. current ratio is that a company’s working capital is expressed as a dollar amount, while current ratio is expressed as a number, such as 1.5 or 2.0. This current ratio number represents how many times over a company could pay off its short-term debt.