"Your Current Ratio is very good." "Your Current Ratio should be better." You probably heard that multiple times when reviewing your financials with your accountant, broker, or CFO. But what is the Current Ratio - is it better when it's higher or when it's lower? How do I calculate my Current Ratio? Can I improve my Current Ratio?
What is the Current Ratio and why is important to have a good Current Ratio?
The Current Ratio, which is also called the working capital ratio, measures a company's ability to pay off its current debt (liabilities that are due less than one year) with its current assets. The Current Ratio is a number expressed between "0" and up. The term “current” usually reflects a period of about 12 months.
The current ratio is widely used by banks and financial institutions while sanctioning loans to companies, and therefore, this is a vital ratio for any company.
If your current ratio is high, it means you have enough cash. The higher the ratio is, the more capable you are of paying off your debts. If your current ratio is low, it means you will have a difficult time paying your immediate debts and liabilities. In general, a current ratio of 2 or higher is considered good, and anything lower than 2 is a cause for concern. However, good current ratios will be different from industry to industry.
How do I calculate my Current Ratio?
The Current Ratio is calculated by dividing current assets (Cash, Accounts Receivables, Inventory, etc.) by current liabilities (Accounts Payable, Credit Cards, etc.). The resulting number is the number of times the company could pay off its current obligations with its current assets.
Current Ratio = Current Assets / Current Liabilities
Let's take an example, a business that has $325,000 in current assets (Cash $75,000, Accounts Receivables $200,000, Inventory $50,000) and $215,00 in current liabilities (Accounts Payables $100,000, Credit Cards $100,000, Current portion on long term liabilities $15,000), the current ratio is $325,000 / $215,000, which is equal to 1.5. That means this hypothetical company can pay its current liabilities one and a half times its current assets.
Is a higher Current Ratio better?
Based on the previous example, it sounds like a higher Current Ratio is better, but the correct answer is that it depends on how it changes month over month. For example, always having a high Current Ratio can result from a few reasons:
Even this company has a high Current Ratio that should present that they have enough cash to pay off all their current obligations; when looking into the details, they will not be able to pay it off with the current cash on hand.
How can I improve my Current Ratio?
✅ The correct answer is to increase your Net Income and make sure to get paid on time!
The following two options won't help your current ratio;
❎ Collecting payment on customers' open invoices.
👉 When doing collections, you move your assets from one account (Receivables) to another (cash in the bank) with no effect on your assets as a whole.
❎ Paying off your bills or short-term debt.
👉 Paying bills using cash will reduce your current assets (cash) and your current liabilities (Accounts Payable) by an equal amount resulting in no change.
You also need to make sure that all your accounts are correctly classified, and that all loans that are not due within one year move to long-term liabilities. If you had a long-term Loan receivable andit's now due in less than a year, you should move it to current assets.
Want to learn more? In this article, we explain the difference between profits and cash flow.
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FAQs
The current ratio is a comparison of a company's current assets to current liabilities that can be used to find its liquidity, usually as a comparison between companies in the same industry. Potential creditors use the current ratio to measure a company's ability to pay off short-term debt.
What is current ratio and why is it important? ›
What Is the Current Ratio? The current ratio is a liquidity ratio that measures a company's ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.
What does a very high current ratio indicate? ›
A rate of more than 1 suggests financial well-being for the company. There is no upper end on what is “too much,” as it can be very dependent on the industry, however, a very high current ratio may indicate that a company is leaving excess cash unused rather than investing in growing its business.
What is considered a healthy current ratio? ›
As a general rule of thumb, a current ratio in the range of 1.5 to 3.0 is considered healthy. However, a current ratio <1.0 could be a sign of underlying liquidity problems, which increases the risk to the company (and lenders if applicable).
What does a current ratio of 2.5 times represent? ›
The current ratio for Company ABC is 2.5, which means that it has 2.5 times its liabilities in assets and can currently meet its financial obligations Any current ratio over 2 is considered 'good' by most accounts.
Why is the current ratio important to managers? ›
Current ratio compares a company's current assets to its current liabilities, essentially measuring a company's ability to fulfil short-term financial obligations. It's a good indicator of financial health and can warn of impending issues if the ratio is too low or even too high.
What does the current ratio affect? ›
According to [10], the Current Ratio is one of the ratios that measures the liquidity of the company. The higher the ability of the company to meet short-term debt, it shows that the company is very good or healthy and will attract investors to invest, so the Stock price will increase.
Is it better for the current ratio to be higher or lower? ›
Generally, a higher current ratio is better than a lower one because it indicates the company has more resources to use to pay its obligations. However, a too high current ratio may suggest the company is not efficiently using its resources and may be holding too much inventory or cash.
Do we want a high or low current ratio? ›
The current ratio is widely used by banks and financial institutions while sanctioning loans to companies, and therefore, this is a vital ratio for any company. If your current ratio is high, it means you have enough cash. The higher the ratio is, the more capable you are of paying off your debts.
What does a current ratio above 4 mean? ›
A very high current ratio could mean that a company has substantial assets to cover its liabilities. However, it could also mean that a business is not using its resources effectively.
High current ratio: This refers to a ratio higher than 1.0, and it occurs when a business holds on to too much cash that could be used or invested in other ways. Low current ratio: A ratio lower than 1.0 can result in a business having trouble paying short-term obligations.
What is a weakness of the current ratio? ›
A weakness of the current ratio is that it doesn't take into account the composition of the current assets. the difficulty of the calculation. that it is rarely used by sophisticated analysts. that it can be expressed as a percentage, as a rate, or as a proportion.
How to interpret the current ratio? ›
The current ratio describes the relationship between a company's assets and liabilities. So, a higher ratio means the company has more assets than liabilities. For example, a current ratio of 4 means the company could technically pay off its current liabilities four times over.
Is 0.2 A good current ratio? ›
A current ratio of 0.2 to 1 means the company has only $0.20 of current assets for every $1 of current liability. This is an indication of the very bad/poor liquidity strength of the company.
Why is a 2 to 1 current ratio bad? ›
Short Answer
2:1 current ratio shows the defensive style of business operation, low investment for growth and limited opportunity.
What's a good quick ratio? ›
Generally speaking, a good quick ratio is anything above 1 or 1:1. A ratio of 1:1 would mean the company has the same amount of liquid assets as current liabilities. A higher ratio indicates the company could pay off current liabilities several times over.
What does a current ratio of 0.8 mean? ›
For example, if a company has a current ratio of 1.5—meaning its current assets exceed its current liabilities by 50%—it is in a relatively good position to pay off short-term debt obligations. Conversely, if the company's ratio is 0.8 or less, it may not have enough liquidity to pay off its short-term obligations.
Is 1.3 in current ratio good? ›
What is a good current ratio? "Banks like to see a current ratio of more than 1 to 1, perhaps 1.2 to 1 or slightly higher is generally considered acceptable," explains Trevor Fillo, Senior Account Manager with BDC in Edmonton, Alberta. "A current ratio of 1.2 to 1 or higher generally provides a cushion.
Why is current ratio and acid test ratio important? ›
Both the current ratio, also known as the working capital ratio, and the acid-test ratio measure a company's short-term ability to generate enough cash to pay off all debts should they become due at once.
