What is the Current Ratio and How Do You Measure It?
What You Need to Know About the Current Ratio
The current ratio is probably the best known and most often used of the liquidity ratios, which analysts and investors use to evaluate the firm's ability to pay its short-term debt obligations, such as accounts payable (payments to suppliers) and taxes and wages. Short-term notes payable to a bank, for example, may also be relevant.
On the balance sheet, the current portions of assets and liabilities are those that either convert to cash within one year, such as one-year Certificates of Deposit or inventory for sale, or short-term loans due within one year. Current assets and current liabilities make up the current ratio.
Calculation of the Current Ratio
The current ratio shows how many times over the firm can pay its current debt obligations based on its current, most liquid assets.
The current ratio is calculated from balance sheet data using the following formula:
Current ratio = Current assets / current liabilities
If a business firm has $200 in current assets and $100 in current liabilities, the calculation is $200/$100 = 2.00X. The "X" (times) part at the end means that the firm can pay its current liabilities from its current assets two times over.
Interpreting the Ratio Result
This is a good financial position for a firm, meaning that it can meet its short-term debt obligations with no stress. If the current ratio is less than 1.00X, then the firm would have a problem covering its monthly bills. A higher current ratio is typically better than a lower current ratio with regard to maintaining liquidity.
Calculating the Quick Ratio
The second step in liquidity analysis is to calculate the company's quick ratio or acid test. The quick ratio is a more stringent test of liquidity than the current ratio formula. It looks at how well the company can meet its short-term debt obligations without having to sell any of its inventory to do so.
Inventory is the least liquid of all the current assets because you have to find a buyer for your inventory. Finding a buyer, especially in a slow economy, is not always possible. Therefore, firms want to be able to meet their short-term debt obligations by using cash and equivalents, without having to rely on selling inventory.
The formula is as follows:
Quick Ratio = Current Assets-Inventory / Current Liabilities.
When looking at a company's balance sheet, suppose it seems they had very small asset balances and a decent amount of debt. For example, a firm's calculation could look like the following:
Quick Ratio = $250/$550 = 0.455 X
This type of outcome would mean that the firm cannot meet its current (short-term) debt obligations without selling inventory because of the quick ratio result of 0.455 X, which is less than the minimum target of 1.0 X.
In order to stay solvent and pay its short-term debt without selling inventory, the quick ratio must be at least 1.0 X, which is not the case in this hypothetical scenario.