If a company doesn’t have enough liquidity to meet its imminent financial obligations, it winds up in an extremely vulnerable position. It will struggle to operate and may fail to find credit for emergencies or opportunities. If it does find credit, that credit will be costly.
As an investor, you need to know if the companies you invest in are healthy and thriving. Part of that analysis is measuring whether the company has the liquidity to pay what it owes. You can do that with the current ratio. Here we’ll help you understand this ratio, its importance, and how to calculate it.
What is the Current Ratio?
The current ratio (sometimes called “working capital ratio”) is a tool that helps investors and creditors understand a company’s liquidity, which is the company’s ability to pay off its short-term liabilities with its current assets. Short-term liabilities include any liabilities that are due within the next year.
You’ve probably heard of liquidity in regards to liquidation sales. This is when a company sells off all of its assets so it can pay its debts. Those “going out of business” events that sell merchandise (including the shelves!) are examples of companies raising cash for liabilities by selling assets.
Healthy companies have high liquidity and thus a high current ratio. This means they can easily afford operations and make their debt payments. It also means they have assets they could sell to raise capital quickly, maybe to launch a new product, enter a new market, or get itself out of a jam. At any time, the owners could pay off all of the liabilities and walk away with money in their pocket.
Companies with low liquidity have low current ratios. These companies struggle to pay for their liabilities and may not even make enough money to pay for their operations. If their businesses fail, investors and creditors could go unpaid.
Furthermore, companies with low liquidity tend to only have assets that generate revenue. This is because they’ve avoided purchasing assets that don’t generate revenue or they’ve sold off revenue-generating assets already. So if they have to raise cash quickly, they can only sell off revenue-generating assets. As you can imagine, this damages the health and long-term growth of the company.
The current ratio is a common metric investors and creditors use to determine if they’ll loan a business more money or purchase equity. Ideally, they only want to lend money to companies who have enough stuff they can sell off to pay the debt in full, otherwise the creditor risks losing money if the business goes under.
How to Calculate the Current Ratio
The current ratio isn’t a complex formula, but it gives you keen insight into a company’s health and survivability. To calculate the current ratio, simply divide current assets by current liabilities. It looks like this:
Current Ratio = Current Assets / Current Liabilities
Note that the formula doesn’t measure assets and liabilities. It measures current assets and current liabilities. What’s the difference?
Current Assets
Current assets are assets on your balance sheet that can be converted into cash within one year. This includes cash (which is already liquid), marketable securities (which are securities you can sell on the market any time), prepaid expenses, accounts receivable, and any supplies and inventory you can sell quickly. This category doesn’t include long-term assets that can’t normally be sold within a year, such as equipment, intellectual property, and real estate.
Current Liabilities
Current liabilities are financial obligations a company has to pay within one year. This includes items like income taxes, payroll taxes, wages, short-term loans, accounts payable, dividends declared, accrued expenses, and the current portions of long-term loans. It does not include items like commercial mortgages.
Current ratios are expressed as whole numbers, not percentages. A current ratio of one or greater means the company has more assets than liabilities, therefore it could pay those liabilities with its current assets if it had to. A company with a current ratio of three means the company has three times more current assets than current liabilities. That’s a sign of a healthy company.
What is a Good Current Ratio?
An ideal current ratio is between 1.2 and 2. Be careful about investing in any company with a current ratio outside that range. Make sure to do your research before buying.
If a company’s ratio is less than one, it means it doesn’t have enough assets to cover its short-term liabilities. That’s a vulnerable position because it will struggle to raise capital to invest in new ventures and products. If it does need to raise money, it will be costly.
A current ratio equal to 1 means the company’s current assets equals its current liabilities. If the business sold everything, it would have just enough to pay its short term liabilities.
If a company’s current ratio is greater than one, it will have no problem paying its liabilities with its current assets. This indicates a healthy business that earns a profit.
That said, it’s not a good sign if a company’s current ratio breaks 2. At face value, lots of assets and few liabilities sounds good, but a high current ratio might indicate that the company isn’t investing its short-term assets efficiently. If, for example, a company has lots of cash on hand (remember cash is a current asset), that may mean that the company isn’t spending money on revenue-generating activities.
Context is always important, however. There might be perfectly good reasons why a company has a current ratio outside of that ideal range.
For instance, a seasonal company may have a low current ratio the off-season, but a higher-than-average current ratio during their busy season. Or a company’s current ratio may spike as it saves cash for a big investment, then fall as it develops that new asset. As an investor, it’s your job to consider the contextual factors.
Current Ratio Example
To help you understand the current ratio, let’s walk through an example.
Meg’s Yarn Boutique is an online store that sells knitting supplies. Meg thinks a brick-and-mortar store would do well in her community, so she applies for a loan from her bank to lease a retail location and stock it with inventory.
Before the bank can give her a loan, it reviews her balance sheet to determine her debt levels. The bank learns that Meg has $150,000 in current liabilities, but only $65,000 in current assets. The bank calculates her current ratio like this:
Current Ratio = $65,000 / $150,000 = 0.43
This means Meg only has enough current assets to pay off 43% of her current liabilities. She is already highly leveraged, making her a risky bet for the bank. If the bank lent her money, her current ratio would fall even further, making it that much harder for her to pay her short-term liabilities.
If Meg’s business failed, she wouldn’t have enough assets to sell off to pay her liabilities, which means at least one of her creditors would suffer. The bank would only be enlarging that problem if it lent her money to open her brick-and-mortar store.
Now let’s use a real life example: At the time of writing this article, Disney has $28.12 billion in current assets and $31.52 billion in current liabilities. That’s a current ratio of 0.89, meaning Disney could only pay 89% of its short-term liabilities if it had to.
Disney is a great example of why context is important. At the moment, Disney is a pretty good bet. Its entertainment, merchandising, and licensing machine is stronger than ever. It recently made some massive acquisitions, and just launched a streaming service that will undoubtedly compete with Netflix, Amazon, and Hulu. Its current ratio is under the ideal range, but probably because it isn’t shy about investing into new revenue-generating activities.
Quick Ratio vs Current Ratio
The quick ratio—also called the acid-test ratio—is a conservative version of the current ratio. It’s also used to calculate a company’s short-term liquidity.
Whereas the current ratio considers all current assets, the quick ratio only considers the most liquid current assets. This category only includes assets that can be converted to cash within 90 days: cash, cash equivalents, accounts receivable, and short-term marketable securities. Unlike the current ratio, the quick ratio does not consider inventory, prepaid expenses, and supplies.
Since the quick ratio considers fewer factors, it’s always lower than the current ratio. By excluding less liquid assets, the quick ratio focus only the assets a company can use immediately to settle liabilities. For instance, inventory is somewhat liquid because it can be sold, but that might take time. Companies may be able to get refunds for prepaid expenses, but again, that takes time.
Is one ratio better than the other? No. In fact, it helps to have both when you evaluate a company to invest in. As always, we have to consider context.
For example, a retail company that has a lot of inventory will report a high current ratio, but a low quick ratio. But having lots of inventory isn’t a bad thing for a retail store because the company has the means to move it quickly if it has to. If we only looked at its quick ratio, its liabilities would seem inflated.
The Bottom Line
The current ratio is a tool we use to measure the short-term financial health of a business. Strong current ratios fall between 1.2 and 2. Before you invest in a company, make sure you understand its current ratio as well as the context for that number.
