Current Ratio Explained With Formula and Examples

What Is the Current Ratio?

The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.

A current ratio that is in line with the industry average or slightly higher is generally considered acceptable. A current ratio that is lower than the industry average may indicate a higher risk of distress or default by the company. If a company has a very high current ratio compared with its peer group, it indicates that management may not be using its assets efficiently.

The current ratio is called current because, unlike some other liquidity ratios, it incorporates all current assets and current liabilities. The current ratio is sometimes called the working capital ratio.

Understanding the Current Ratio

The current ratio measures a company’s ability to pay current, or short-term, liabilities (debts and payables) with its current, or short-term, assets, such as cash, inventory, and receivables.

In many cases, a company with a current ratio of less than 1.00 does not have the capital on hand to meet its short-term obligations if they were all due at once, while a current ratio greater than 1.00 indicates that the company has the financial resources to remain solvent in the short term. However, because the current ratio at any one time is just a snapshot, it is usually not a complete representation of a company’s short-term liquidity or longer-term solvency.

For example, a company may have a very high current ratio, but its accounts receivable may be very aged, perhaps because its customers pay slowly, which may be hidden in the current ratio. Some of the accounts receivable may even need to be written off. Analysts also must consider the quality of a company’s other assets vs. its obligations. If the inventory is unable to be sold, the current ratio may still look acceptable at one point in time, even though the company may be headed for default.

A ratio under 1.00 indicates that the company’s debts due in a year or less are greater than its cash or other short-term assets expected to be converted to cash within a year or less. In general, the higher the current ratio, the more capable a company is of paying its obligations because it has a larger proportion of short-term asset value relative to the value of its short-term liabilities.

However, though a high ratio—say, more than 3.00—could indicate that the company can cover its current liabilities three times, it also may indicate that it is not using its current assets efficiently, securing financing very well, or properly managing its working capital. This is why it is helpful to compare a company's current ratio to those of similarly-sized businesses within the same industry.

Formula and Calculation for the Current Ratio

To calculate the ratio, analysts compare a company’s current assets to its current liabilities.

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Current assets listed on a company’s balance sheet include cash, accounts receivable, inventory, and other current assets (OCA) that are expected to be liquidated or turned into cash in less than one year.

Current liabilities include accounts payable, wages, taxes payable, short-term debts, and the current portion of long-term debt.

Using the Current Ratio

A current ratio of less than 1.00 may seem alarming, but a single ratio doesn't always offer a complete picture of a company's finances.

For example, a normal cycle for the company’s collections and payment processes may lead to a high current ratio as payments are received, but a low current ratio as those collections ebb. Calculating the current ratio at just one point in time could indicate that the company can’t cover all of its current debts, but it doesn’t necessarily mean that it won’t be able to when the payments are due.

As another example, large retailers often negotiate much longer-than-average payment terms with their suppliers. If a retailer doesn’t offer credit to its customers, this can show on its balance sheet as a high payables balance relative to its receivables balance. Large retailers can also minimize their inventory volume through an efficient supply chain, which makes their current assets shrink against current liabilities, resulting in a lower current ratio.

The current ratio can be a useful measure of a company’s short-term solvency when it is placed in the context of what has been historically normal for the company and its peer group. It also offers more insight when calculated repeatedly over several periods.

Changes in the current ratio over time can often offer a clearer picture of a company's finances. A company that seems to have an acceptable current ratio could be trending toward a situation in which it will struggle to pay its bills. Conversely, a company that may appear to be struggling now could be making good progress toward a healthier current ratio.

In the first case, the trend of the current ratio over time would be expected to harm the company’s valuation. Meanwhile, an improving current ratio could indicate an opportunity to invest in an undervalued stock amid a turnaround.

Imagine two companies with a current ratio of 1.00 today. Though they may appear to have the same level of risk, analysts would have different expectations for each company depending on how the current ratio of each had changed over time.

In this example, the trend for Company B is negative, meaning the current ratio is decreasing over time. An analyst or investor seeing these numbers would need to investigate further to see what is causing the negative trend. It could be a sign that the company is taking on too much debt or that its cash balance is being depleted, either of which could be a solvency issue if the trend worsens.

On the other hand, the trend for Company A is positive. This could indicate that the company has better collections, faster inventory turnover, or simply a better ability to pay down its debt. The trend is also more stable, with all the values being relatively close together and no sudden jumps or increases from year to year. An investor or analyst looking at this trend over time would conclude that the company's finances are likely more stable, too.

This is markedly different from Company B's current ratio, which demonstrates a higher level of volatility. From 2020 to 2021, it jumps from 1.35 to 1.05 in a single year. This could indicate increased operational risk and a likely drag on the company’s value.

Example Using the Current Ratio

To see how current ratio can change over time, and why a temporarily lower current ratio might not bother investors or analysts, let's look at the balance sheet for Apple Inc.

In its Q4 2022 fiscal results, Apple Inc. reported total current assets of $135.4 billion, slightly higher than its total current assets at the end of the 2021 fiscal year of $134.8 billion. However, the company's liability composition significantly changed from 2021 to 2022. At the end of 2022, the company reported $154.0 billion of current liabilities, almost $29 billion greater than current liabilities from 2021.

For 2021, Apple had more current assets than current liabilities. Its current ratio was:

$134.836 billion / $125.481 billion = 1.075

If all current liabilities of Apple had been immediately due at the end of 2021, the company could have paid all of its bills without leveraging long-term assets.

At the end of 2022, however, Apple's current ratio was:

$135.405 billion / $153.982 billion = 0.88

Apple technically did not have enough current assets on hand to pay all of its short-term bills.

However, most analysts would not have been concerned, since Apple is a well-established company that could quickly move products through production, sell inventory, or secure short-term financing (with its $217 billion of non-current assets pledged as collateral, for instance).

And by the end of the 2023 fiscal year, the picture had changed yet again. Apple's current assets were $143.7 billion, while its current liabilities were nearly $134 billion, making its current ratio:

$143.692 billion / $133.973 billion = 1.07

This is once again in line with the current ratio from 2021, indicating that the lower ratio of 2022 was a short-term phenomenon.

Current Ratio vs. Other Liquidity Ratios

Other similar liquidity ratios can supplement a current ratio analysis. In each case, the differences in these measures can help an investor understand the current status of the company’s assets and liabilities from different angles, as well as how those accounts are changing over time.

The commonly used acid-test ratio, or quick ratio, compares a company’s easily liquidated assets (including cash, accounts receivable, and short-term investments, excluding inventory and prepaid expenses) to its current liabilities. The cash asset ratio, or cash ratio, also is similar to the current ratio, but it only compares a company’s marketable securities and cash to its current liabilities.

Companies may use days sales outstanding to better understand how long it takes for a company to collect payments after credit sales have been made. While the current ratio looks at the liquidity of the company overall, the days sales outstanding metric calculates liquidity specifically to how well a company collects outstanding accounts receivables.

Finally, the operating cash flow ratio compares a company’s active cash flow from operating activities (CFO) to its current liabilities. This allows a company to better gauge funding capabilities by omitting implications created by accounting entries.

Limitations of Using the Current Ratio

One limitation of the current ratio emerges when using it to compare different companies with one another. Businesses differ substantially among industries; comparing the current ratios of companies across different industries may not lead to productive insight.

For example, in one industry, it may be more typical to extend credit to clients for 90 days or longer, while in another industry, short-term collections are more critical. Ironically, the industry that extends more credit actually may have a superficially stronger current ratio because its current assets would be higher.

Another drawback of using the current ratio involves its lack of specificity. Unlike many other liquidity ratios, it incorporates all of a company’s current assets, even those that cannot be easily liquidated. For example, imagine two companies that both have a current ratio of 0.80 at the end of the last quarter. On the surface, this may look equivalent, but the quality and liquidity of those assets may be very different:

In this example, Company A has much more inventory than Company B, which will be harder to turn into cash in the short term. Perhaps this inventory is overstocked or unwanted, which eventually may reduce its value on the balance sheet. Company B has more cash, which is the most liquid asset, and more accounts receivable, which could be collected more quickly than liquidating inventory. Although the total value of current assets matches, Company B is in a more liquid, solvent position.

The current liabilities of Company A and Company B are also very different. Company A has more accounts payable, while Company B has a greater amount in short-term notes payable. This would be worth more investigation because it is likely that the accounts payable will have to be paid before the entire balance of the notes-payable account. Company A also has fewer wages payable, which is the liability most likely to be paid in the short term.

In this example, although both companies seem similar, Company B is likely in a more liquid and solvent position. An investor can dig deeper into the details of a current ratio comparison by evaluating other liquidity ratios that are more narrowly focused than the current ratio.

The Bottom Line

The current ratio is a liquidity measurement used to track how well a company may be able to meet its short-term debt obligations. It compares the ratio of current assets to current liabilities. Measurements less than 1.0 indicate a company's potential inability to use current resources to fund short-term obligations.

The current ratio provides the most information when it is used to compare companies of similar sizes within the same industry. Since assets and liabilities change over time, it is also helpful to calculate a company's current ratio from year to year to analyze whether it shows a positive or negative trend.