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What is the Current Ratio?

Views 29KOct 9, 2023
What is the Current Ratio? -1

Key Takeaways 

  • The current ratio is a liquidity ratio that measures a company's ability to pay its current liabilities with its current assets

  • In theory, the higher the current ratio, the more capable a company is of paying its current obligations

  • Weaknesses of the current ratio include the difficulty of comparing the measure across industry groups, the overgeneralization of the specific asset and liability balances, and the lack of information on trends

Understanding Current Ratio

The current ratio is a liquidity ratio that measures a company's ability to cover its current liabilities (liabilities that will be paid in a year or less) with its current assets (assets that are cash or will be turned into cash in a year or less).

To calculate the ratio, analysts compare a company's current assets to its current liabilities.

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Current assets listed on a company's balance sheet include cash, accounts receivable, inventory, and other current assets that are expected to be liquidated or turned into cash in less than one year. 

Current liabilities include accounts payable, wages, taxes payable, short-term debts, the current portion of long-term debt, etc.

What counts as a good current ratio will depend on the company's industry and historical performance. As a general rule, however, a current ratio of less than 1.00 could seem alarming, indicating that a company does not have enough working capital on hand to meet its short-term debts if they were due at once.

In theory, the higher the current ratio, the more capable a company is of paying its obligations because it has a larger proportion of short-term asset value relative to the value of its short-term liabilities. However, a very high ratio may also indicate that it is not using its current assets efficiently.

Limitations of Current Ratio

One limitation of the current ratio emerges when using it to compare different companies across industries. As different businesses require different liquidity, comparing the current ratios of companies across different industries may not result in productive insights.

Another drawback of using the current ratio involves its lack of specificity. Unlike many other liquidity ratios, it incorporates all the current assets of a company, even those that cannot be easily liquidated. 

What's more, because the current ratio at any one time is just a snapshot, it is usually not a sufficient indicator of a company's short-term liquidity or longer-term solvency.

Example of Current Ratio

The chart below is the balance sheet from $Apple(AAPL.US)$ annual report for the fiscal year ended September 25, 2021. It reveals the company's total current assets and total current liabilities on September 25, 2021.

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The total current assets of Apple on September 25, 2021, were 134.836 billion.

The total current liabilities of Apple on September 25, 2021, were 125.481 billion.

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Disclaimer: This content is for informational and educational purposes only and does not constitute a recommendation or endorsement of any specific investment or investment strategy.

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