Accounting: Current Ratio
The current ratio is the most popular measure of the short-term ability to pay debts. It is calculated by dividing total current assets by total current liabilities. (Assets and liabilities are usually considered “current” if they will be paid or converted into cash within one year.) The current ratio is essentially a measure of liquidity, the ability to pay current liabilities with current assets.
In general, it is better to have a high current ratio, as this will reassure potential lenders and investors that the business can pay off its debts. However, there is some disagreement about the ideal current ratio. Some businesses have a target ratio of 1.5 (that is, current assets are 150% of current liabilities), though some risk-averse banks set a minimum current ratio of 2 for potential borrowers.
In some cases, however, a high current ratio can be a red flag. An excessively high ratio could indicate that the business is not taking enough risks, and that the assets of the business are not being put to good use.
As always with financial ratios, proper analysis must include a consideration of the industry. Different business types will have different targets. For instance, retailers generally have higher current ratios than wholesalers or manufacturers, because they have to keep more inventory on hand and because they are subject to unpredictable changes in revenue. Similarly, large businesses tend to have lower current ratios than small ones, because they are able to meet their obligations even when revenues are unexpectedly low.
That’s the current ratio in a nutshell. Now, test your knowledge with this short quiz!