The current ratio, sometimes called the quick ratio, is a liquidity ratio that measures a company’s coverage of its current liabilities by its current assets. It tracks the short-term solvency of the business by assessing the number of times the short-term assets, those that will be converted into cash in less than 12 months, cover the short-term liabilities, which are those that will be due in less than 12 months.
What is the Current Ratio?
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Measuring a company’s financial health is particularly important to determine its creditworthiness as well as its capacity to fulfill its current financial commitments. A business liquidity is what holds everything together, as long as the business has enough cash to pay for its debt, it will be able to continue operating without an issue. In turn, a business that doesn’t have enough cash to fulfill its commitments, even though it may be profitable, will eventually succumb to insolvency and potentially to bankruptcy.
For this reason, analysts, lenders and investors employ the current ratio to measure a business capacity to pay for its short-term debt. The current assets, those that are highly liquid, should always exceed the current liabilities. The degree in which they exceed it may vary from one industry to the other, but a situation in which a business has less current assets than current liabilities should not occur and if it does it will put the business at great risk.
Current Ratio Formula
The current ratio formula is calculated like this:
CR = Current Assets / Current Liabilities
Current Ratio Equation Components
Current Assets: The sum of all assets that will be potentially turned into cash in less than 12 months. This includes cash, cash equivalents, inventory, receivables, and others.
Current Liabilities: The sum of all liabilities that will be potentially due in the next 12 months. This includes payables, the short-term portion of long-term debt, accrued liabilities and others.
The result will be expressed as the number of times the current assets cover for the current liabilities.
Additionally, there are other similar metrics such as the Quick Ratio, which measures how many times the business’ current assets minus its inventory (and other current assets that take more time to be converted into cash), cover for the business liabilities. This metric is also known as the ‘acid test’.
Current Ratio Example
Fast Burgers is a business that has 11 restaurants located across the state of New York, where they offer gourmet burgers. The company is currently analyzing the possibility of expanding to other states, and in order to do so, they want to apply for a loan.One of the conditions established by the lenders is that the company has to have at least a current ratio of 2. The CEO of Fast Burgers, therefore, asked the Finance Manager to look into this to make sure the company complies with that condition. The business’ up to date Balance Sheet provides the following information:
Current Assets:
- Cash – $210,000
- Cash Equivalents – $12,500
- Account Receivables – $24,000
- Inventory – $567,000
- Other current assets – $54,000
Total Current Assets = $867,500
Current Liabilities:
- Account Payables – $453,000
- Accrued Liabilities – $110,000
- Short-Term Debt – $43,000
Total Current Assets = $606,000
By using this information, the Finance Manager can calculate the Current Ratio as follows:
CR = $867,500 / $606,000 = 1.43
This means that the company doesn’t comply with the minimum requirement established by the bank and therefore it has to come up with a way to increase the ratio.
Current Ratio Analysis
A healthy current ratio opens many doors to a company. A healthy liquidity along with decent profitability will probably get most lenders on board, and this is the reason why analyzing the current ratio is an important task for Finance Manager and also for any investor looking into a potential opportunity.
A current ratio of 1 indicates that the business has exactly the same amount of current assets as it has of current liabilities. This means that a current ratio of more than 1 indicates a higher amount of current assets compared to current liabilities and the opposite is true if the metric’s result is lower than 1.
While it is theoretically impossible for a business to operate successfully with a Current Ratio lower than 1, in some cases it will be possible as long as the business has money to pay for the commitments at the moment they are due. Even though, eventually it will end up defaulting on something if the situation is not fixed quickly.
A healthy current ratio is usually one higher than 1.5. This means the business has at least 50% more assets than liabilities, which gives the company some degree of flexibility to meet its financial commitments.
In the example above, the company has a ratio lower than the bank’s minimum requirement. In order to achieve the ratio of 2 demanded by the lender, they could either decide to pay off some of the liabilities by employing the cash they have and by liquidating some of the inventory, or they could also do their best to boost sales and increase the amount of the current assets with the earnings coming from the sales. Another solution would be to liquidate or sell some of the business’ fixed assets, if they have some that are not really essential to the operation. The proceeds will be added to the cash account, which will increase the current assets.
Current Ratio Uses, Cautions, Pitfalls
Even though the Current Ratio measures the business liquidity in theory, the actual capacity of the company to pay for its debt timely can only be assessed through a comprehensive cash flow that identifies when the company has to pay and whether they will have money to do so or not. This creates the possibility for a company to operate with a negative Current Ratio for a while, as long as its Cash Flow Budget shows the company has the funds to pay for its commitments on time.
Companies that are experiencing a sales downturn may step into below 1 territory for a while and this doesn’t necessarily mean they will go bankrupt, even though the situation is highly risky and it is not advisable that they operate as such for a considerable period of time.