Liquidity Measurement Ratios: Current Ratio

The current ratio measures the ability of a company to cover its short-term liabilities with its current assets.

The formula is:

• Current assets divided by current liabilities

As an example, a company with $10 million in current assets and $5 million in current liabilities would have a current ratio of 2.0 times.

A current ratio of 1.0 or greater is an indication that the company is well-positioned to cover its current or short-term liabilities.

A current ratio of less than 1.0 could be a sign of trouble if the company runs into financial difficulty.

Cautions in using this ratio

When looking at the current ratio, investors should be aware that this is not the whole story on company liquidity. It’s also important  to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities.

For example, how quickly can the company collect all of its outstanding accounts receivables? An analyst would want to look at the company’s days sales outstanding which is a measure of how long it takes the company to receive payment after a sale is made.

For companies with inventory, how quickly can this inventory be liquidated should the need arise and what percentage of the inventory’s value would the company be likely to receive? Looking at the company as a going concern, an analyst would want to calculate the company’s inventory turnover ratio, a measurement of how long it takes a company to turnover or sell its inventory.

The current ratio inherently assumes that the company would or could liquidate all of most of its current assets and convert them to cash to cover these liabilities. In reality this is unlikely if the company is to remain as a going concern. A certain level of working capital will still be needed.

Companies with a seemingly high current ratio may not be safer than a company with a relatively low current ratio. Beyond just looking at the current ratio, an analyst would need to look at the composition and quality of the company’s current assets. The current ratio is just one of many financial indicators that potential investors and creditors will need to analyze.