Current ratio definition

What is the current ratio?

The current ratio is a measure used to establish a company’s ability to sell its tangible assets to pay off its short-term debt. Companies normally have a limited time to settle short-term debt, so the current ratio is useful in establishing the liquidity position of a business.

Current ratio formula

The current ratio is calculated by dividing the value of a company’s tangible assets by the value of its liabilities. Tangible assets can be converted into a monetary value – including vehicles, buildings and machinery – while liabilities include longer-term debt, such as salaries and taxes.

Example of calculating current ratio

Assume company ABC has $1.5 billion in assets and $1 billion in liabilities (debt). The current ratio will be equal to 1.5 ($1.5 billion/$1 billion).

What does the current ratio show?

The current ratio shows a company’s ability to pay off debt. It can have a significant impact on how traders and investors see a company, which means the ratio can influence the share price. A high current ratio could have a positive effect on share prices, while a low current ratio could cause stock prices to drop.

What is a good current ratio?

A good current ratio should be higher than one. This would indicate that the company can cover its liabilities with its assets. If the current ratio is lower than one, it could mean that the company has too many liabilities to cover with assets alone and it might have to take out additional loans.

A very high current ratio could mean that a company is not using its assets and equity efficiently. Further, a current ratio that is always changing is also not a good sign, as this means the business cannot maintain a steady cash flow.

Pros and cons of current ratios

Pros of current ratios

Current ratio can give you an understanding of a company’s financial strength without having to go into too much detail. It can also be useful in determining how efficient a business is in terms of optimising production, and selling off assets (how quickly it can convert assets to cash). Lastly, it gives you an idea of how management handles liabilities and debt repayments.

Cons of current ratios

The current ratio alone cannot give you insight into the liquidity of a company because rather than assessing the quality of the assets, it only tells us how many assets exist. If the assets are of a low quality, there could still be issues involved in selling them.

Current ratio is also not a truly comparable measure because different companies have different inventory management methods. It is also easy to manipulate the current ratio due to factors such as seasonal sales; the ratio can change from season to season due to fluctuations in the number of products being sold.