One of the financial ratios you have at your disposal to analyse a company’s position and performance is the current ratio. The current ratio, along with the quick ratio, will help you understand a company’s liquidity. In other words, it will help you know whether a company has enough liquid (and therefore current) assets to cover and repay the liabilities that will fall due very soon. So we will have a look at the current ratio formula, work through some examples and then use the online calculator.
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 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 we expect to fall due within the next financial year.
As noted above, the current ratio shows whether a company can repay the current liabilities as they are falling due. In other words, if the current ratio is higher than one, 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 in which the company operates or with other similar companies is considered more appropriate. Furthermore, when analysing the company, it’s suggested to compare the current position with historical data. Preferably, you use a three to five-year horizon, enabling you to add comparability and identify trends.
A lower current ratio means the company risks not paying its current liabilities as they fall 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.
Company A has $500,000 cash and $200,000 stock while the accounts payable is $1,000,000. Now let’s assume that you can recover the full $700,000 balance representing the current assets quickly. The above example company will be unable to pay part (or $300,000) of its suppliers.
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 two (1,000,000 / 500,000), and the current ratio for company B is 0.67. Therefore, company A seems to cover its current liabilities by its current assets, with a 500,000 headroom. On the other hand, company B might face difficulties repaying 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 by 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.