Current ratio is a liquidity ratio that shows a company’s ability to pay short-term obligations. The formula is current assets divided by current liabilities.

The current ratio is an accounting ratio that shows a company’s ability to pay its vendors, creditors, and expenses in the near term. This metric is referred to as a liquidity ratio because it measures how liquid current assets are in order to understand a company’s ability to pay its short-term obligations.

The current ratio is also called the working capital ratio, these two are different names for the same formula. Other liquidity ratios include the cash ratio and quick ratio which we will discuss later.

The current ratio formula is:

Current Ratio = Current Assets / Current Liabilities

Current assets are assets that are expected to convert to cash within 1 year. urrent assets include the following balance sheet accounts: cash and cash equivalents, commercial paper, marketable securities, government bonds, accounts receivable, inventory, supplies, and prepaid expenses.

Current liabilities are liabilities that must be paid within 1 year. Current liabilities include the following balance sheet accounts: accounts payable, notes payable, dividends payable, short-term debt, payroll, wages, salaries, and taxes.

You calculate current ratio by dividing current assets by current liabilities. Here is the formula:

Current Ratio = Total Current Assets / Total Current Liabilities

The current ratio is used to show a company’s ability to cover its short-term obligations. The ratio is a snapshot of a company’s health at a moment in time. As such, you must make sure that you are looking at the same dates for assets and liabilities.

If you wanted to run the current ratio for January 15th, you would use the January 15th balance for total current assets and total current liabilities. If you wanted the average for the month of January, you would average the balance sheet accounts for the whole month before putting them into the current ratio formula.

Here are two examples that we will use to calculate the current ratio.

Company A

- Current Assets, Fiscal Year 2019: $650,000
- Current Assets, Fiscal Year 2020: $700,000
- Current Liabilities, Fiscal Year 2019: $450,000
- Current Liabilities, Fiscal Year 2020: $750,000

We are going to start by calculating the ratio for 2019:

Current Ratio = Current Assets / Current Liabilities

Current Ratio = $650,000 / $450,000

Current Ratio = 1.44x

Now let’s look at Company A in 2020:

Current Ratio = Current Assets / Current Liabilities

Current Ratio = $700,000 / $750,000

Current Ratio = 0.93x

As we can see, Company A’s financial position was weakened from 2019 to 2020. A high current ratio (above 1.0x) means that the company has enough cash and other near-term assets to cover its expenses and debt.

Meanwhile, a low current ratio (below 1.0x) means that a company does not have enough short-term assets to cover its current liabilities. This is an unhealthy financial position.

The current ratio is used by executives, managers, investors, and other stakeholders to understand how likely a company is to meet its current obligations. As discussed above, a high ratio means that the company is in a healthier position and is likely to meet its obligations. A low ratio means the company is at risk for not repaying its obligations.

Like other accounting ratios, the current ratio is highly dependent on company stage and industry. An early-stage startup may have a poor current ratio, but that might be justified if the investors understand the risk profile. The same applies to different industries.

A company in manufacturing or transportation might have significant cash tied up in long-term assets, like factories or trucks. This would look reflect poorly on their current ratio (low cash position). This means the company is not very liquid. The current ratio is best when utilized to compare a company’s current position to itself in prior periods, or to evaluate different companies in the same industry.

There are several liquidity ratios, including current ratio, cash ratio, and quick ratio. Some of these metrics also have multiple names. Let’s dig into it now.

Current Ratio = Current Assets / Current Liabilities

Current Ratio is also called Working Capital Ratio

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Quick Ratio = Quick Assets / Current Liabilities

Quick Ratio is also called the Acid-Test Ratio or Acid Ratio

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

All of these accounting ratios show a company’s ability to repay its short-term obligations. Depending on the industry and specific situation, it might be more beneficial to look at one or another. However, we recommend tracking all three measures.

Current ratio measures the ability for a company to meet its short-term liabilities with its short-term assets. This liquidity measure is an important one for finance managers, accounting managers, and executive leadership to keep eyes on.

Investors and lenders would also look at the current ratio to understand the financial strength and viability of a business. In particular, they would be concerned if a company is generating enough profit to cover its existing short-term financing facilities (like lines of credit or loans).

Here are the key takeaways:

- Current Ratio = Current Assets / Current Liabilities
- The current ratio is also referred to as the working capital ratio
- A current ratio more than 1.0x means the company has more short-term assets than short-term liabilities, which is good
- A current ratio less than 1.0x is a dangerous position, as the company might not have enough liquid assets to cover its near-term obligations
- This metric is called a liquidity ratio because it measures how liquid a company is, or how easily assets could be converted to cash