The current ratio measures the liquidity of a business and its ability to meet its short term liabilities and debts. It is calculated by dividing current assets by current liabilities. For this reason it is also known as the Working Capital Ratio.
Current Ratio Formula
- Current assets are given in the balance sheet and includes cash, accounts receivable, and inventory.
- Current liabilities are also found in the balance sheet and includes accounts payable and short term (due in less than 1 year) debt. There is discussion as to whether overdrafts should be included in the current ratio calculation. Strictly speaking overdrafts are payable on demand and are therefore part of current liabilities. In practice under normal circumstances, a bank will view the business relationship as an ongoing one and overdrafts could be excluded. In the balance sheet format used below overdrafts have been left out of the calculation.
How to Calculate Current Ratio in Practice
Calculation Example 1:
|Long term assets||390,000|
|Total liabilities and equity||540,000|
In the above example the current assets are 150,000 and the current liabilities are 100,000. Accordingly the current ratio is calculated as follows:
Current ratio = (Current Assets - Inventory) / Current Liabilities Current ratio = 150,000 / 100,000 Current ratio = 1.50
Calculation Example 2:
|Long term assets||220,000|
|Total liabilities and equity||350,000|
In Example 2 above the current assets are 130,000 and the current liabilities are 160,000. Accordingly the current ratio is calculated as follows:
Current ratio = (Current Assets - Inventory) / Current Liabilities Current ratio = 130,000 / 160,000 Current ratio = 0.81
Current Ratio Interpretation
It is generally considered that current assets are readily convertible to cash, what the current ratio shows is the ability of the business to generate enough cash to repay its current liabilities should they all be demanded at once.
In example 1 above the current ratio is 1.50 which means therefore that for every 1 the business owes it can quickly generate 1.50 in cash to make payment.
In example 2 above the current ratio is 0.81 and therefore the business is only able to generate cash of 0.81 for every 1 it owes. Clearly in the unlikely event of all current liabilities being demanded at the same time the business would be unable to make payment.
An increasing current ratio over time indicates that the business is either tying up more and more money in inventory and accounts receivable, which might indicate a lack of efficiency in inventory control or debt collection, or it is paying its suppliers too quickly.
A current ratio which is reducing overtime shows that inventory and accounts receivable are reducing or that further credit is being taken from suppliers, possibly showing the onset of liquidity problems in the near future.
Useful tips for Using the Current Ratio
- The current ratio will vary from industry to industry. Therefore to make comparisons you need to use a comparable business operating in your sector.
- A current ratio in the region of 1.5 is normally considered acceptable. Basically the higher the ratio the more liquidity the business has. However a ratio which is too high implies a lot of money tied up in inventory and accounts receivable or as cash sitting in the bank. It is generally accepted that money tied up in this way earns very little or nothing for the business.
- Some businesses, particularly low margin supermarkets, operate with negative working capital which means that current assets are less than current liabilities and the current ratio is less than 1. Providing the level of risk (in not being able to repay all liabilities on demand) is acceptable then it shows that the business is able to fund its investment in inventory and accounts receivable using credit from its suppliers thereby reducing its borrowings.
- Finally, a bank manager may include overdraft facilities in the calculations, and will want to see a high current ratio (heading towards 2.00) as it shows a lower risk business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.