Calculation Formula | Examples | What Is "Good" | Analysis & Interpretation | Definition & Meaning
You’ve probably heard before that the current ratio is the ‘standard test’ of a company’s liquidity position.
But what does that really mean?
The core idea behind the current ratio is that a business should have enough current assets (= cash and near-cash assets that can be converted into cash within 1 year) available to meet its commitments to pay off its current liabilities (= short-term obligations due within 1 year) as they fall due.
Why? Let me explain.
If the point of the current ratio is to show that a company has enough cash coming in to satisfy its short-term liability commitments, then you would expect to see a ratio–comfortably–in excess of 1, right?
Otherwise, the company may not be able to pay its short-term debt obligations on time.
This table illustrates this point:
| Current Ratio | Meaning of Current Ratio |
|---|---|
| 1:1 | Current ratio of 1:1 means that current liabilities can be FULLY paid out of the existing current assets (if they all fell due at once). |
| 2:1 | Current ratio of 2:1 means that current liabilities can be paid TWICE over out of the existing current assets. |
So, superficially speaking, a ratio between 1:1 and 2:1 is the norm for most businesses to be regarded as creditworthy.
| Current Ratio | Standard Interpretation of Current Ratio |
|---|---|
| 0.5:1 | Minimum for businesses with low-cash/low-receivables/high-payables |
| 1:1 | Acceptable minimum |
| 1.5:1 | Appropriate ratio |
| 2:1 | Desirable ratio |
In practice, however, what is expected and comfortable varies widely between industries and different types of businesses, even though a ratio in excess of 1 is generally desirable.
In fact, many businesses in many industries–such as supermarkets–operate perfectly fine with ratios way below 1.
Supermarkets tend to operate on low current ratios because there are:
As a result, the average supermarket group may easily have a current ratio of 0.50 or even lower.
Therefore, the current ratio should be looked at in the light of what is common in the industry the business is in.
Since the relative liquidity position is more important than the absolute figures, remember to consider the trend of the current ratio and compare it to previous periods, competitors, industry and the economy as a whole.
A significant decrease in the current ratio year-on-year or a figure that is below the industry average benchmarks could indicate that a company has liquidity problems.
A supermarket has successfully operated for years with current ratios around 0.40, which is consistent with the industry average.
In the current year, the ratio suddenly falls to 0.20, while the industry average has remained the same.
In this scenario, it is a good idea to investigate the reason behind the decrease in current ratio and assess the overall liquidity situation of the company.
The supermarket could take steps to improve liquidity by managing working capital more efficiently, including inventory, accounts payable and receivable.
Yes, the higher the current ratio, the more financially secure the entity may appear.
Beware though, the current ratio can get too big.
This could suggest inefficient management of working capital, which is tying up more cash in the business than needed.
For example:
When evaluating the current ratio, it is also worth considering the nature of the inventory in the business.
In some businesses, like manufacturing, the turnover of inventory is particularly slow.
As a result of the lengthy cash cycle, the stock is not a very ‘liquid’ asset.
For this reason, a quick ratio–also known as acid test ratio–exists as an alternative to the current ratio.
The quick ratio / acid test ratio is calculated just like the current ratio, but with inventory deducted from current assets.
Such calculation provides a more accurate picture of the short-term liquidity of the company.
Read this full post dedicated to the quick / acid test ratio.
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