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The current ratio indicates a company’s ability to meet its short-term obligations. 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 liabilities that are expected to be paid within a year.
Investors can use this type of liquidity ratio to make comparisons with a company’s peers and competitors. Ultimately, the current ratio helps investors understand a company’s ability to cover its short-term liabilities with its current assets.
Why the current ratio matters
When investing in a company, you need to consider the current ratio. When a company’s current ratio is relatively low, it is a sign that the company may not be able to pay off its short-term debt as it matures, which could damage its creditworthiness or even lead to bankruptcy.
For example, a company’s current ratio may appear good, when in reality it has declined over time, indicating a deteriorating financial condition. But a current ratio that is too high can indicate that a company is not investing effectively, leaving too much unused cash on the balance sheet.
The current ratio must be placed in the context of the company’s historical performance and that of its peers. A current ratio can be better understood by looking at how it changes over time.
The current ratio is part of what you need to understand when investing in individual stocks, but those who invest in mutual funds or stock market funds don’t have to worry about it.
How to calculate current ratio
You can calculate the current ratio by dividing a company’s total current assets by its total current liabilities. Again, current assets are resources that can be quickly converted into cash in a year or less, including cash, accounts receivable, and inventory.
Current liabilities include accounts payable, wages, accrued expenses, accrued interest, and short-term liabilities.
The formula is:
Current ratio: Current assets / Current liabilities
Example of current proportions
Let’s look at some examples of companies with high and low current ratios. You’ll find these figures on a company’s balance sheet under total current assets and total current liabilities. Some financial sites also give you the ratio in a list of other common financial data, such as valuation, profitability and capitalization. You can find the current ratio with other liquidity ratios.
- General Electric (GE) current assets as of December 2023 were $65.5 billion; current liabilities were $51.95 billion, bringing the current ratio to 1.26.
- Target’s (TGT) current ratio in 2023 was 0.99: current assets were $21.57 billion and current liabilities were $21.75 billion.
- Intel (INTC) had $43.27 billion in current assets and $28.05 billion in current liabilities at the end of 2023, for a high current ratio of 1.54.
What is a good current ratio?
The ideal current ratio varies by industry. However, an acceptable range for the current ratio might be 1.0 to 2. Ratios within this range indicate that the company has enough current assets to cover its debt, with some wiggle room. A current ratio that is lower than the industry average may mean the company is at risk of bankruptcy and is generally a riskier investment.
However, special circumstances may influence the meaning of the current ratio. For example, a financially healthy company may have an expensive one-time project that requires funding, such as for emergency building improvements. Because buildings are not considered current assets and the project is eating into cash reserves, the current ratio could fall below 1.00 until more money is made.
Likewise, companies that generate cash quickly, such as well-managed retailers, can safely operate with lower current ratios. They can borrow from suppliers (which increases accounts payable) and actually receive payments from their customers before the money is due to those suppliers. For example, Walmart had a current ratio of 0.83 in January 2024. In this case, a low current ratio reflects Walmart’s strong competitive position.
The best long-term investments manage their money effectively, meaning they keep the right amount of cash on hand for the needs of the business.
What is a bad current ratio?
A current ratio of less than 1.0 indicates that a company’s liabilities due within a year or less exceed its assets. A low current ratio could indicate that the company may be having difficulty meeting its short-term obligations.
However, similar to the example we used above, special circumstances can negatively impact the current ratio in a healthy company. For example, imagine company XYZ, which has a large receivable that is unlikely to be collected, or excess inventory that may be obsolete. Both circumstances could at least temporarily lower the current ratio.
Current ratio vs. quick ratio vs. debt/equity
Other measures of liquidity and solvency that are similar to the current ratio may be more useful, depending on the situation. For example, although the current ratio takes into account all of a company’s current assets and liabilities, it does not take into account the credit terms of customers and suppliers, or operating cash flows.
A more conservative measure of liquidity is the quick ratio – also known as the acid test ratio – which compares only cash and cash equivalents to short-term liabilities. In contrast, the current ratio includes all of a company’s current assets, including those that may not be easily converted into cash, such as inventory, which can be a misleading representation of liquidity.
To measure solvency, a company’s ability to repay long-term debts and obligations, you need to consider its debt-to-equity ratio. This ratio compares a company’s total liabilities to its total shareholders’ equity. It measures how much creditors contributed to a company’s financing compared to shareholders and is used by investors as a measure of stability. A company with high debt is generally a riskier investment.
In short
The current ratio is just one indicator of financial health. Like most performance measures, it must be taken together with other factors for well-contextualized decision making.
