The current ratio is used to evaluate a company's ability to pay its short-term obligations, such as accounts payable and wages. It's calculated by dividing current assets by current liabilities. The higher the result, the stronger the financial position of the company.
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.
What Is the Current Ratio?
The current ratio, which is also called the working capital ratio, compares the assets a company can convert into cash within a year with the liabilities it must pay off within a year. It is one of a few liquidity ratios—including the quick ratio, or acid test, and the cash ratio—that measure a company's capacity to use cash to meet its short-term needs.
On the balance sheet, current assets include cash, cash equivalents (investments that mature in three months or less and are easily converted into cash, such as government bonds, commercial paper, and money market funds), accounts receivable, and inventory.
Current liabilities include accounts payable, income taxes payable, wages payable, and dividends declared, which are, respectively, amounts owed to suppliers, income taxes owed to the federal government, employee wages earned but not yet paid, and dividends approved and declared by the board of directors but not yet paid.
How Do You Calculate the Current Ratio?
The current ratio is calculated simply by dividing current assets by current liabilities. The resulting number is the number of times the company could pay its current obligations with its current assets.
How the Current Ratio Works
Let's say a business has $150,000 in current assets and $100,00 in current liabilities. The current ratio is $150,000 / $100,000, which is equal to 1.5. That means the company in question can pay its current liabilities one and a half times with its current assets.
If a company has $2.75 million in current assets and $3 million in current liabilities, its current ratio is $2,750,000 / $3,000,000, which is equal to 0.92, after rounding.
A current ratio of less than 1 means the company may run out of money within the year unless it can increase its cash flow or obtain more capital from investors. A company with a high current ratio has no short-term liquidity concerns, but its investors may complain that it is hoarding cash rather than paying dividends or reinvesting the money in the business.
Limitations of the Current Ratio
Two items that are often used when calculating current assets are not easily converted into cash: accounts receivable (money other companies owe the company in question) and inventory (completed products and the materials used to create them). For that reason, the current ratio may not be the best measure of a company's short-term liquidity.
The cash ratio replaces current assets with only cash and cash equivalents—the most-liquid assets a company can own—so it eliminates the potential liquidity problem associated with inventory and accounts receivable.
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.
How to Calculate the Current Ratio in Excel
You can find online Excel templates that will help you keep track of current assets and liabilities and enable you to easily calculate the current ratio. You can also enter the current assets figure in one cell—say, A6—and current liabilities in the next cell down, A7. You can then enter =A6/A7 in a cell to calculate the result.
- The current ratio is used to evaluate a company's ability to pay its short-term obligations—those that come due within a year.
- The current ratio is calculated by dividing a company's current assets by its current liabilities.
- The higher the resulting figure, the more short-term liquidity the company has.
- A current ratio of less than 1 could be an indicator the company will be unable to pay its current liabilities.