Current Ratio

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What is the Current Ratio?

The current ratio is a liquidity ratio that assesses a business's capacity to settle short-term debt or bills that are due within a year. It explains to analysts and investors how a business might optimize its current assets on the balance sheet to pay down its current debt and other payables. 

It is generally accepted to have a current ratio that is either comparable to or somewhat higher than the industry standard. 

A current ratio that is below the industry norm can be a sign of increased default or distress risk. In a similar vein, an excessively high current ratio for the company relative to its peer group suggests that management may not be making the best use of its resources. The term working capital ratio can be used to refer to the current ratio.

Why Current Ratio is Important?

The current ratio is important because it provides a snapshot of a company's liquidity and solvency. Because it offers a quick glance at a company's liquidity and solvency, the current ratio is significant. A company's liquidity is its capacity to swiftly and readily turn its assets into cash. The capacity of an organization to fulfill its long-term financial commitments is referred to as solvency. 

A company's reputation and credit rating can be improved by having a high current ratio since it increases the likelihood that it will have sufficient cash or liquid assets to pay its creditors on time. 

A business with a low current ratio may struggle to meet its financial obligations and experience cash flow issues, which could harm the business's credit score and reputation. An excessive amount of cash or inventory held by a corporation with a high current ratio may lower its profitability and return on assets.

Formula for Current Ratio

The formula for the current ratio is:

Current Ratio = Current Assets / Current Liabilities

Assets that can be turned into cash in a year or less are known as current assets. These consist of marketable securities, cash and cash equivalents, inventory, accounts receivable, and other current assets.

Liabilities that are due in less than a year are referred to as current liabilities. They consist of short-term loans, wages, taxes due, accounts payable, and the present share of long-term debt.

How to calculate the current ratio

A company's current ratio can be computed by dividing its current assets by its current liabilities. The assets that can be turned into cash or utilized to settle outstanding debts within a year are known as current assets. 

The current ratio can be expressed as a number or as a percentage. For example, if a company has $60 million of current assets and $30 million of current liabilities, its current ratio is:

Current Ratio = 60 / 30 = 2

This means that the company has twice as much current assets as current liabilities. Alternatively, the current ratio can be expressed as:

Current Ratio = (60 / 30) x 100% = 200%

This means that the company's current assets are 200% of its current liabilities.

Examples of the current ratio

Let's examine a few corporations from various industries and compare their current ratios to show how the current ratio is used to evaluate a company's liquidity.

Apple Inc. (AAPL)

As of September 25, 2021, Apple had $121.7 billion of current assets and $106 billion of current liabilities, giving it a current ratio of:

Current Ratio = 121.7 / 106 = 1.15

This indicates that Apple's current liabilities were slightly greater than its current assets.

Walmart Inc. (WMT)

As of July 31, 2021, Walmart had $69.6 billion of current assets and $83.4 billion of current liabilities, giving it a current ratio of:

Current Ratio = 69.6 / 83.4 = 0.83

Walmart may have a liquidity issue as a result of having less current assets than current liabilities.

Exxon Mobil Corporation (XOM)

As of June 30, 2021, Exxon Mobil had $54.8 billion of current assets and $51 billion of current liabilities, giving it a current ratio of:

Current Ratio = 54.8 / 51 = 1.07

Essentially, this indicates that Exxon Mobil's current assets were somewhat greater than its current liabilities.

Limitations of the current ratio

The current ratio is a useful indicator of a company's short-term liquidity, but it also has some limitations that should be considered when interpreting it.

• The quality or profitability of the current assets and liabilities are not reflected in the current ratio. For instance, a high current ratio can result from having a lot of outdated or slow-moving inventory, while a low current ratio might come from having a lot of accounts payable that suppliers are willing to accept on good terms.
• The time and cash flow patterns of the current assets and liabilities are not taken into consideration by the current ratio. For instance, if the business can sell its marketable securities or collect its receivables promptly, a low current ratio might not be an issue; conversely, if the business has to pay off its obligations before it can enjoy its cash inflows, a high current ratio might not be enough.
• A company's long-term solvency or leverage cannot be inferred from the current ratio. It may be difficult for the business to satisfy its long-term obligations if, for instance, a high current ratio is combined with a high debt-to-equity ratio or a low-interest coverage ratio.
• Depending on their business strategies and operational cycles, several businesses and sectors may have quite varied current ratios. For instance, because they have higher turnover rates and smaller inventory levels than manufacturing organizations, retail enterprises typically have lower current ratios. Comparing the present ratios of businesses within the same industry or sector is therefore more informative than doing so across different ones.

FAQ

How successfully a corporation can use its current assets to satisfy its short-term obligations is shown by its current ratio. A corporation with a greater current ratio is more liquid and able to pay down its debts and other payables with ease. A reduced current ratio suggests that a business can struggle to make its debt payments, potentially experiencing liquidity issues or even going bankrupt.

The definition of a good or acceptable current ratio is ambiguous because it can vary depending on a number of circumstances, including the industry, business cycle, stage of growth, and company. A current ratio of one or above, however, is generally seen as satisfactory since it indicates that the business has sufficient current assets to meet its current liabilities. 

If the company's current ratio is less than 1, it can mean that it needs to sell some assets or take out a larger loan in order to pay off its debts. A extremely high current ratio, nonetheless, can also indicate that the business is not making investments in its expansion or employing its resources effectively.

Although there are other liquidity measures as well, the current ratio is one of the most widely employed. The cash ratio, operating cash flow ratio, and quick ratio (sometimes known as the acid-test ratio) are further liquidity ratios. Since they take out of the numerator some less liquid current assets like inventory and prepayments, these ratios are stricter than the current ratio. For instance, only cash, marketable securities, and accounts receivable are regarded under the quick ratio as quick assets that are easily convertible into cash.

The nature of their business operations, working capital management, development possibilities, and competitive climate can all have a substantial impact on the current ratio in different industries and during different time periods. For instance, current ratios may be lower in high inventory turnover industries like retail or food services than in low inventory turnover industries like manufacturing or utilities. In a similar vein, industries with greater growth potential or intense competitiveness could have current ratios that are higher than those with lower potential for growth or less intense competition.