The current ratio, commonly referred to as the current liquidity ratio or the working capital ratio, is one of the most important liquidity measures to assess a business’ performance. This post will take a dive into the concept of the current ratio, its interpretation, and an example of the same.
The current ratio measures a business’ ability to meet its short-term obligations that are due within a year. Further, this ratio is a measure of the financial health and solvency of a business as it indicates how a business can maximize the liquidity of its current assets to settle debt and payables.
Current ratio formula
Current assets are the assets of a company that can be converted into cash within a year. Examples of current assets include cash and cash equivalents, prepaid expenses, inventory, account receivables, short term investments and others.
Current liabilities are short-term financial obligations that are expected to be due within one year such as lease payments, wages, accounts payables, and short-term bank loans/ debt, etc.
Interpretation of current ratio:
Current ratios vary by industry; however, a current ratio of less than 1 usually indicates that the company’s current liabilities are more than its current assets and the business may not be able to cover its short-term debt with its existing short-term financial resources.
A current ratio of more than one implies that the company has more financial resources for covering its short-term debt and it is operating under stable financial solvency.
When compared to industry standards, an extremely high current ratio indicates that the business is not able to manage its working capital in an efficient manner.
One must note that it is essential to compare the current ratio of a company with its industry peers rather than comparing it in a generalized manner. If the current ratio of a company is considerably lesser than the industrial average, then one must dig deeper to investigate what is the cause of that outcome. The same is applicable to companies that have substantially higher current ratios in comparison to their industry peers. Further, an analysis of a company’s current ratio trend over the past years is an important tool one can use to assess business performance. A steady rise in the current ratio indicates that the company is working on improving its liquidity whereas a decline in the current ratio over the years usually indicates that the financial stability of the company has been worsening.
So, is a current ratio of less than 1 always a bad sign?
No. One must always look at the industry in which the business operates. An interesting example can be the U.S. supermarket giant Walmart Stores Inc. Over the years, Walmart has maintained a current ratio lower than 1. For the three months ended April 30, 2022, Walmart’s current ratio was 0.86.
If this figure is looked at individually, one may think Walmart may be in financial trouble. However, when compared to the supermarket industry in the U.S., this ratio is favorable as Walmart can turn its inventories around and collect its receivables quickly. Hence, it is not imperative for the company to have a current ratio that is more than 1 to do well.
If Co. ABC holds the following:
- Cash and cash equivalents – $10 million
- Marketable securities – $15 million
- Inventory – $35 million
- Short term debt – $10 million
- Accounts payable – $20 million
The current ratio will be calculated as given below:
Current Assets = Cash and cash equivalents + Marketable securities + Inventory
Current Assets = $60 million
Current Liabilities = Short term debt + Accounts payable
Current Liabilities = $30 million
Current Ratio = 2