Current ratio

Before you rely on it

What to check

Look at what the current assets actually consist of.

The common error

Where people go wrong with current ratio

Counting slow inventory at cost as though it were cash. A ratio of two looks safe right up until the point where half of it is stock nobody is buying at the price it is carried at.

Worked through

Current ratio in plain numbers

A company has $500,000 in current assets: $120,000 in cash, $180,000 in receivables and $200,000 in inventory. Its current liabilities are $250,000. The current ratio is 500,000 ÷ 250,000, or 2.0, and the company holds two dollars of short-term assets for each dollar due within a year. Now suppose inventory is slow-moving and worth only half its stated value. Assets fall to $400,000 and the ratio to 1.6; the quick ratio, which leaves out inventory, is 300,000 ÷ 250,000, or 1.2. The quality of the assets matters as much as the total.

Easily confused

Current ratio and its neighbours

The current ratio is a cousin of the quick ratio and the cash ratio, each stricter than the last; the current ratio counts all current assets. The quick ratio leaves out inventory and prepaid items. The cash ratio counts only cash and equivalents. Working capital is the dollar difference between current assets and current liabilities, where the ratio divides them; a company can have positive working capital and a weak ratio, or the reverse. Which measure fits depends on how quickly assets can be turned into cash.

In real decisions

Where current ratio turns up

Lenders, suppliers and analysts use it to judge whether a business can meet its bills in the next year. Loan agreements often set a minimum current ratio as a covenant; owners track it monthly. Credit departments check it before extending terms. Comparing to industry peers matters, since a grocery chain with fast inventory can run a much lower ratio than a manufacturer with slow stock and still be healthy.

Know the edges

Where current ratio stops being reliable

A high ratio is not always good: it may mean idle cash or bloated inventory; a low ratio may be fine for firms that collect cash quickly. The measure is a snapshot on the balance sheet date and can be dressed up by timing payments; it ignores the timing of cash flows within the year. Combine it with cash flow, receivable days and inventory turnover. Ratios differ by industry, so compare like with like.

Quick answers

What people ask about current ratio

What is a good current ratio? Rules of thumb say between 1.5 and 2, but it depends on the industry. A grocer with quick inventory can run lower. A manufacturer with slow stock may need more.

Can the ratio be too high? Yes. A very high ratio can mean idle cash, excess inventory or slow-collecting receivables. Ask what the assets are and how fast they turn.

How does the ratio change if I pay down a loan? Paying a current liability with cash lowers both sides equally. If the ratio is above one, it rises, since the same dollars leave both assets and liabilities.

What does a ratio below one mean? Current liabilities exceed current assets. It may signal a liquidity problem, or a business model that collects cash quickly. Look at cash flow and payment terms.