One of the many financial ratios that you have at your disposal to analyze the position and the performance of a company is the current ratio. The current ratio along with the quick ratio will help you understand the liquidity of a company. In other words, it will help you understand whether a company has enough liquid (and therefore current) assets to cover and repay the liabilities that will fall due in the very near future.
Current Ratio Formula
The current ratio formula is very straightforward. The numerator includes the current assets and the denominator the current liabilities. Therefore, the current ratio formula is:
Current Ratio= Current Assets/Current Liabilities
Examples of current assets that are included are cash and cash equivalents, accounts receivable and stock (or inventory). On the other hand, current liabilities include your trade creditors (or accounts payable), your short-term debt (short-term bank loans, overdraft facilities) and other liabilities that are expected to fall due within the next financial year.
Current Ratio Analysis
As noted above, the current ratio shows whether a company is able to repay the current liabilities as they are falling due. In other words, if the current ratio is higher than 1, then the company is believed to be in a better shape to repay the current liabilities from its current assets. Preferably, a company should have a current ratio higher than 1.5 but comparing this ratio with the industry which the company operates in or with other similar companies is considered more appropriate. Furthermore, when analyzing the a company, it’s suggested to compare the current position with historical data. Preferably, you use a 3-5 years horizon which will enable you to add comparability and identify trends.
A current ratio that is lower than 1 means that the company risks being unable to pay its current liabilities as they are falling due. In other words, it might be the case that the company will be unable to pay its suppliers or the short-term loan and the consequences might not be pleasant.
Current Ratio Example
Example 1: Company A has $500,000 cash and $200,000 stock while the accounts payable is $1,000,000. Now let’s assume that the full $700,000 balance that represents the current assets can be recovered in a short period. The above example company will be unable to pay part (or $300,000) of its suppliers.
Example 2: Let’s say that we have two companies. Company A has $1,000,000 current assets and $500,000 current liabilities. Company B operates in the same industry and has $2,000,000 current assets and $3,000,000 current liabilities.
The current ratio for Company A is 2 (1,000,000/500,000) and the current ratio for company B is 0.67. Therefore, company A seems to be able to cover its current liabilities by utilizing its current assets and there is also a 500,000 headroom. On the other hand, company B might face difficulties repaying all its current liabilities since the current assets are not enough.
Current Ratio Calculator
The calculator that you will find below calculates the current ratio by dividing the current assets with the current liabilities. Current assets include all assets that are due within the next financial year such as cash and cash equivalents, inventory, accounts receivable and prepaid expenses. Current Liabilities include liabilities such as accounts payable, accruals and short-term debt.