Let’s look at examples of how the current ratio can be used to evaluate a company’s financial health. We’ll also explore why the current ratio is essential to investors and stakeholders, the limitations of using the current ratio, and factors to consider when analyzing a company’s current ratio. The current ratio accounts for all of a company’s assets, whereas the quick ratio only counts a company’s most liquid assets. The current ratio, therefore, is called “current” because, in contrast to other liquidity ratios, it incorporates all current assets (both liquid and illiquid) and liabilities. A Current Ratio greater than 1 indicates that a company has more assets than liabilities in the short term, which is generally considered a healthy financial position. It suggests that the company can comfortably cover its current obligations.
Companies with shorter operating cycles, such as retail stores, can survive with a lower current ratio than, say for example, a ship-building company. The current ratio should be compared with standards — which are often based on past performance, industry leaders, and industry average. The limitations of the current ratio – which must be understood to properly use the financial metric – are as follows. The current ratio reflects a company’s capacity to pay off all its short-term obligations, under the hypothetical scenario that short-term obligations are due right now.
The current ratio helps investors and stakeholders assess a company’s financial risk by measuring its ability to pay off short-term debts. A low current ratio may indicate a company’s difficulty meeting its short-term obligations, which can be a red flag for investors and stakeholders. A current ratio above 2 may indicate that a company has many cash or other liquid assets that are not used effectively to generate growth or investment opportunities.
A strong Current Ratio can instill confidence in potential investors, but it should be evaluated alongside other financial metrics and the company’s specific circumstances. A ratio greater than 1 means that the company has sufficient current assets to pay off short-term liabilities. Current assets refer to cash and other resources that can be converted into cash in the short-term (within 1 year or the company’s normal operating cycle, whichever is longer). Another practical measure of a company’s liquidity is the quick ratio, otherwise known as the “acid-test” ratio. Here, the company could withstand a liquidity shortfall if providers of debt financing see the core operations are intact and still capable of generating consistent cash flows at high margins.
The current ratio can also analyze a company’s financial health over time. Let’s say that Company E had a current ratio of 1.5 last year and a current ratio of 2.0 this year. This suggests that Company E has improved its ability to pay its short-term debts and obligations over the past year. The current ratio is an essential introduction to bookkeeping financial metric because it provides insight into a company’s liquidity and financial health. A high current ratio suggests that a company has a strong ability to meet its short-term obligations. They include cash, accounts receivable, inventory, prepaid expenses, and other assets a company expects to use or sell quickly.
However, you have to know that a high value of the current ratio is not always good for investors. A disproportionately high current ratio may point out that the company uses its current assets inefficiently or doesn’t use the opportunities to gain capital from external short-term financing sources. If so, we could expect a considerable drawdown in future earnings reports (check the maximum drawdown calculator for more details). The company has just enough current assets to pay off its liabilities on its balance sheet. Current ratios are not always a good snapshot of company liquidity because they assume that all inventory and assets can be immediately converted to cash.
In such cases, acid-test ratios are used because they subtract inventory from asset calculations to calculate immediate liquidity. During times of economic growth, investors prefer lean companies with low current ratios and ask for dividends from companies with high current ratios. To compare the current ratio of two companies, it is necessary that both of them use the same inventory valuation method.
The ratio is calculated by dividing current assets by current liabilities. An asset is considered current if it can be converted into cash within a year or less, while current liabilities are obligations expected to be paid within one year. This ratio compares a company’s current assets to its current liabilities, testing whether it sustainably balances assets, financing, and liabilities. Typically, the current ratio is used as a general metric of financial health since it shows a company’s ability to pay off short-term debts.
The current ratio only considers a company’s short-term liquidity, which may not provide a complete picture of its financial health. A company may have a high current ratio but still have long-term financial challenges, such as high debt or low profitability. A company with a consistently high current ratio may be financially stable and well-managed. In contrast, a company with a consistently low current ratio may be considered financially unstable and risky.
To measure solvency, which is the ability of a business to repay long-term debt and obligations, consider the debt-to-equity ratio. It measures how much creditors have provided in financing a company compared to shareholders and is used by investors as a measure of stability. Similarly, companies that generate cash quickly, such as well-run retailers, may operate safely with lower current ratios. They may borrow from suppliers (increasing accounts payable) and actually receive payment from their customers before the money is due to those suppliers.
