Current Ratio Definition
The current ratio is balance-sheet financial performance measure of company liquidity. The current ratio indicates a company's ability to meet short-term debt obligations. The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months. Potential creditors use this ratio in determining whether or not to make short-term loans. The current ratio can also give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. The current ratio is also known as the working capital ratio.
Current Ratio Formula
The current ratio is calculated by dividing current assets by current liabilities:
Both variables are shown on the balance sheet (statement of financial position).
How to Calculate Current Ratio (Example)
To calculate the current ratio of a U.S. company using its balance sheet, you must first determine its current assets and current liabilities.
Current assets are assets that are expected to be converted into cash or used to pay off short-term obligations within one year. Examples of current assets include cash, accounts receivable, marketable securities, and inventory.
Current liabilities are obligations that are due to be paid within one year. Examples of current liabilities include accounts payable, short-term loans, and wages payable.
To calculate the current ratio, divide the total of the company's current assets by the total of its current liabilities. For example, if a company has $100,000 in current assets and $50,000 in current liabilities, its current ratio would be 2.0 (100,000 / 50,000).
What is the normal value of current ratio?
The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's a comfortable financial position for most enterprises. Acceptable current ratios vary from industry to industry. For most industrial companies, 1.5 may be an acceptable current ratio.
Generally, a ratio of 1.5 - 2.0 is considered a normal and acceptable value, meaning that the company has $1.50 to $2.00 of current assets to cover each dollar of current liability. A high current ratio may indicate that the company is not efficiently managing its current assets, while a ratio below 1.0 may indicate that the company may struggle to make its short-term payments in a timely manner. It is important for investors to analyze a company's current ratio to get an understanding of its short-term financial health.
Low values for the current ratio (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, an investor should also take note of a company's operating cash flow in order to get a better sense of its liquidity. A low current ratio can often be supported by a strong operating cash flow.
If the current ratio is too high (much more than 2), then the company may not be using its current assets or its short-term financing facilities efficiently. This may also indicate problems in working capital management.
All other things being equal, creditors consider a high current ratio to be better than a low current ratio, because a high current ratio means that the company is more likely to meet its liabilities which are due over the next 12 months.
It is well established that liquidity ratios, such as the current ratio, quick ratio, and cash ratio, are important metrics for assessing a company’s financial health. Q Saleem and RU Rehman (2011) conducted research to explore the relationship between liquidity ratios and profitability. Their findings indicate that current ratio and quick ratio have a positive correlation with profitability, while cash ratio has a negative correlation. This suggests that a higher current ratio and quick ratio increase profitability, while a higher cash ratio decreases profitability. Furthermore, the study found that the correlation between profitability and liquidity ratios is stronger for firms with higher leverage. This indicates that liquidity ratios are especially important for highly leveraged firms. Therefore, it is critical for such companies to maintain a good liquidity position in order to ensure their profitability.
Are there any regulatory requirements for the value of the current liquidity ratio?
There are no specific regulatory requirements for the value of the current ratio in the US or EU. However, regulators may consider a company's current ratio as part of a broader evaluation of its financial health. For example, in the US, the Securities and Exchange Commission (SEC) requires public companies to file financial statements that include their current ratio and other financial metrics, but there is no specific requirement for the value of the current ratio.
In the EU, the current ratio is often considered as part of the financial reporting requirements under International Financial Reporting Standards (IFRS), but there is no specific requirement for the value of the current ratio.
While there are no specific regulatory requirements for the current ratio, it is generally considered a useful tool for evaluating a company's short-term financial health, and many lenders and investors use it as part of their financial analysis. Companies with a healthy current ratio are often viewed as being more creditworthy and better able to meet their short-term obligations.
Formula in the ReadyRatios Analysis Software
F1 – Statement of financial position (Balance sheet).
Current Ratio Industry Benchmark
As of 2021, some industries tend to have higher current ratios than others, such as utilities and consumer staples. Conversely, industries such as technology and biotechnology tend to have lower current ratios.
About Liquidity and Profitability Correlation
The liquidity-profitability tradeoff has been a long-standing debate in the finance literature. According to AMA Eljelly's International Journal of Commerce and Management (2004), this study empirically investigates the tradeoff between liquidity and profitability in an emerging market. The study focuses on the relationship between liquidity and profitability, taking into account the effect of other variables. The study samples a total of 40 listed firms from the Saudi stock market, using financial ratios to measure liquidity and profitability. The findings of the study suggest that the Saudi stock market is characterized by a negative relationship between liquidity and profitability. The results also indicate that the liquidity-profitability tradeoff is affected by the size of the firm, leverage, and the age of the firm. The study then concludes that the liquidity-profitability tradeoff does exist in the Saudi stock market, and that the effect of the other variables is significant in determining the relationship. This study provides important insight into the effects of liquidity and profitability in an emerging market and the effect of other variables on the relationship between the two.
Current Ratio Limitations
There are several limitations to using the current ratio as a measure of a company's financial health:
Short-term focused: The current ratio only considers a company's ability to meet its short-term obligations, and does not provide information on its long-term financial stability.
Industry differences: Different industries have different norms for their current ratios, and a high or low current ratio for one company may not be considered high or low for another company in a different industry.
Quality of assets: The current ratio does not consider the quality of a company's assets, only their liquidity. For example, if a company has a high level of inventory that is slow-moving, this may not be an effective use of its assets, despite being included in the current ratio calculation.
Timing of obligations: The current ratio does not take into account when obligations are due, and a company may have difficulty meeting its obligations even if its current ratio is healthy.
Limited information: The current ratio only provides a snapshot of a company's financial health, and should be used in conjunction with other financial metrics and analysis to get a more complete picture.
Overall, the current ratio can be a useful tool for assessing a company's short-term financial health, but it should not be used in isolation and should be considered in the context of the company's overall financial position and industry norms.