The current ratio is the measure of the short-term liquidity of a company. It shows the ability of a company to meet its short-term liability through its current assets.
It is important to understand the current ratio, how it works, and what information it provides to the users. It does not offer much as a standalone figure.
The current ratio can be used to assess a company’s current asset utilization and cash flow management. It has several other advantages to offer as well.
Let us discuss the current ratio, formula, and its interpretation.
Current Ratio – Definition
The current ratio is the ability of a company to meet its current liabilities using its current assets. It is the measure of the short-term liquidity of a company.
The current ratio is focused on the current liabilities and assets. Thus, it is also known as the working capital ratio. Cash flow management is an integral part of working capital management.
The current ratio above 1 is considered good, below one is perceived as bad. Similarly, a ratio of 1.0 is considered safe as well. However, a standalone figure does not offer a comprehensive evaluation of a company’s liquidity.
Current Ratio – Formula
The current ratio is the measure of a company’s liquidity in the short term. Thus, it is calculated simply by comparing a company’s current assets against its current liability.
The current ratio formula is given here:
Current Ratio = Current Asset / Current Liabilities
The ratio is calculated in absolute terms rather than in percentage.
Current assets include cash, inventory, accounts receivable, and so on.
Current liabilities include short-term loans, wages, accounts payable, and so on.
Understanding Current Ratio
As the formula above suggests, the current ratio is evaluating a company’s short-term obligations. Since it compares current assets against current liabilities, it can also be used as a measure of working capital efficiency. The current ratio measures the ability of a company to utilize its current assets properly.
It evaluates the capability of a company to fulfill its short-term obligations such as trades payable, wages, estimated monthly taxes, etc. Through readily available current assets such as cash, inventory, and accounts receivable.
Usually, a ratio above 1.0 is considered a good current ratio. A ratio equal to 1.0 is considered safe and below 1.0 is bad. The ratio can be further evaluated in detail by analyzing the nature and availability of current assets and current liabilities.
A company’s current assets include:
- Cash and Cash equivalents
- Inventory, raw material, finished goods
- Accounts receivable
- Office supplies
- Advance payments
An important point to understand the current ratio is to analyze the current assets of a company on a line-by-line basis. For instance, a company with a larger proportion of cash and cash equivalents will be in a better position than a company with more accounts receivable.
Similarly, a company that has a large proportion in the form of raw material or inventory will take more time to convert these assets into cash. Thus, it will be considered less efficient in terms of the current ratio.
A company’s current liabilities include:
- Short-term bank loans
- Accounts payable and trade payable
- Wages and salaries
- Deferred revenues
- Current portion of long-term loans
A company’s current ratio can fall below 1.0 if it has more current liabilities than its current assets. It means the company cannot meet its obligation through its available current assets immediately.
Analyzing each line item under the current liabilities section can help understand more about the liquidity and solvency of the company. For instance, a company can negotiate trade terms to extend its trade or accounts payable.
On the other hand, if a company’s current liabilities show a significant portion coming from bank loans, it will be difficult for the company to negotiate the extension terms with the bank.
Let us consider a real-world example of Amazon Inc. To understand the current ratio formula and its working mechanism.
The following data is extracted from the balance sheet of Amazon for the last three years. All figures are given in millions of US $.
|Item||Year 2020||Year 2019||Year 2018|
|Cash on Hand||$ 84,396||$ 55,021||$ 41,250|
|Accounts Receivable||$ 24,542||$ 20,816||$ 16,677|
|Inventory||$ 23,795||$ 20,497||$ 17,174|
|Other current assets||–||–||–|
|Total Current Assets – A||$ 132,733||$ 96,733||$ 75,101|
|Total Current Liabilities – B||$ 126,385||$ 87,812||$ 68,391|
|Current Ratio = A/B||1.0502||1.097||1.098|
Amazon has maintained a healthy current ratio of above 1 in the last three years. Despite a significant increase in the current liabilities for the year 2020, the company maintained a current ratio of above 1.
Interpretation of Current Ratio
The first important point to remember is to analyze the current ratio through trend analysis. A static figure of around 1.0 does not provide full details about a company’s short-term liquidity.
As we can see in our example above, Amazon has maintained a current ratio of above for the last three years. Despite a significant increase in its current liabilities, the company generated sufficient cash to meet its current liabilities.
Another key aspect is to evaluate a company’s current ratio against similar companies in the same industry. Managers can use the ratio for benchmarking analysis as well. It will further clarify the situation as to how well a company is performing in terms of liquidity.
A too high current ratio cannot be desirable as well. It only means the company is not utilizing its current asset efficiently. Shareholders can interpret that the company has no NPV projects to invest in despite having large current assets.
Similarly, a too low current ratio would mean the company has not maintained sufficient current assets to meet its obligations. Thus, the company may face liquidity issues.
In either case, the current ratio alone cannot be used to evaluate a company’s long-term liquidity and solvency. For instance, a company may face a seasonal fall in sales due to economic or market risks that broadly affect all businesses.
The current ratio is a useful metric when analyzed in the broader context. It should be used for analyzing trends and benchmarking for performance evaluation of a company. A line-by-line analysis of items under current assets and liabilities can further provide details on the liquidity situation.
Advantages of Current Ratio
Managers, shareholders, and creditors can all use the current ratio to assess a company’s liquidity position. It offers several advantages to its users.
- It provides a snapshot of the working capital position of a company.
- It is easy to understand and a widely used ratio.
- Managers can interpret the ratio for further analysis.
- It helps managers analyze trend analysis and benchmarking.
- All stakeholders including shareholders and creditors can understand the ratio easily.
Limitations of Current Ratio
Despite its simplicity and usefulness, the current ratio comes with some limitations as well.
- It is not useful for comparing companies in different industries or different sizes.
- A standalone current ratio does not offer valuable information.
- It does not differentiate between liquid and illiquid assets for the short-term conversion.
- Managers can manipulate historic figures to show favorable results. For example, accounts receivable and payables can be adjusted by controlling the payments.
- The current ratio depicts historic figures that may not be useful for future analysis of a company’s growth prospects.