What Is Current Ratio? Definition and Examples
There are many accounting methods companies use to track their liquid assets. Current ratio is one such method that looks at a company’s ability to pay its short-term debts. Understanding and using this important metric can help your company track its current financial obligations and stay within budget.
In this article, we define current ratio, how to calculate and interpret it using examples and how the principles of current ratio differ from other liquidity ratios.
Related: Your Guide To Careers in Finance
What is current ratio?
Current ratio is a type of liquidity ratio (the ability for the debtor to pay their debts). It is used as a financial measure in companies that span across industries to weigh a company's ability to match its assets to its liabilities by the end of the year. It is also called working capital.
How to calculate current ratio
The following three steps will identify the components necessary, and how to apply them to the formula to calculate the current ratio.
1. Identify current assets
The first step in calculating a company's current ratio is to identify the current assets on the company's balance sheets. Assets include accounts receivable, inventory, cash and anything else that is most likely going to be turned into cash or liquidated within the next year.
2. Identify current liabilities
The second step in calculating a company's current ratio is to identify the current liabilities that are listed on the company's balance sheets. Liabilities can be defined as wages, accounts and taxes payable and the current amount of debt.
3. Compare assets to liabilities
Now that you have the total amounts of assets and liabilities, you can compare them by completing the following equation.
Current ratio = Current assets/Current liabilities
How to interpret the results
Once the current ratio has been calculated, there are multiple ways that the resulting figure can be interpreted to determine a company's financial standing. The following list will review the three main categories that a company's score can fall into.
1. If a current ratio is under 1
If a company calculates its current ratio to be under 1, that is an indication that its current assets will not be able to cover its debts that are due at the end of the year.
2. If a current ratio is at 1
If a company calculates its current ratio to be at, or slightly above, 1 then this means that the company's assets will be able to cover its debts that are due at the end of the year.
3. If a current ratio is above 3
If a company calculates its current ratio at or above 3, this means that the company might not be utilizing its assets correctly. This misuse of assets can present its own problems to a company's financial well-being.
How is current ratio different from other ratios?
The current ratio is seen as the most basic form of liquidity ratios a company can use to compare its assets and liabilities. Other ratios that companies use to determine their financial standings include the quick ratio and the operating cash flow ratio. The following list will review these ratios and provide examples as to how they differ from current ratio strategies.
1. Current ratio
The current ratio is used to determine a company's short-term debts that can be paid off within one year. This liquidity ratio uses the total amount of assets, even those that may not be immediately available, in comparing the amount of debt to the number of available funds to pay it off.
Current ratio = current assets/current liabilities
Example: A manufacturing company needs to calculate its current ratio to determine the likelihood of matching its assets to its liabilities by the end of the year. The company adds up its current assets to total $132.00 million and its current liabilities total $128.35 million. To calculate the current ratio, they complete the following equation:
By using this equation, the company is able to determine that the current ratio is 1.02. Because the current ratio rests just above 1, the manufacturing company will be able to pay off its current liabilities with its assets at the end of the year.
2. Operating cash flow ratio
The operating cash flow ratio is used by a company when it wants to see what current debt can be eliminated by applying a payment from its current income instead of its assets. This type of liquidity ratio uses the cash generated from company operations rather than using cash from a company's investments.
Operating cash flow ratio = operation cash flow/current liabilities
Example: The same manufacturing company wants to determine if it can pay off its current liabilities by using its current income instead of its assets. The company totals the amount of revenue they acquire from company operations to get $121.83 million. The company then totals its current liabilities to be $128.35 million. They enter these numbers into the following equation to see if the money made from operations will be enough to pay off its current liability.
In this instance, the company's operating cash flow ratio is 0.95. As it rests just below 1, this means that its revenue from operations should be able to pay off most of its current liabilities.
Related: How To Calculate Operating Cash Flow
3. Quick ratio
The quick ratio or acid-test ratio is a liquidity ratio used by a company when it is in need of cash to immediately pay off its debts. This ratio helps measure a company's likelihood to match current liabilities to the assets that can be quickly sold.
Quick ratio = current assets - (investments and prepayments) /current liabilities
Example: This time, the manufacturing company is in need of immediate funds to pay its current liabilities. In this situation, the company decides to use the quick ratio to determine how they can pay off their debt relatively fast. In order to do this, the company must first separate its investments and prepayments from its current assets, as these funds will not be readily accessible to them.
They determine that their total current assets are $132.00 million. From this, they separate their company's investments and prepayments. The portion of their current assets that are investments and prepayments totals $32.00 million. Their current liabilities remain at $128.35 million. Using the following equation, they determine whether their current assets without inaccessible revenue will be enough to match their current liabilities.
After completing the equation, the quick ratio comes up as 0.78. As this number rests a bit below 1, this means that the company's current assets without investments and prepayments can only pay for a portion of their immediate debt.
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