The Current Ratio explained.

The Current Ratio (CR) is a “liquidity ratio” that measures a company’s ability to meet its short-term obligations. It is calculated by comparing the current assets to current liabilities. This ratio is used alongside the Quick Ratio to see the short-term obligations coming due within one year.

The term “Current” refers to the business’s current ability to pay short-term liabilities like debts and payables, with its short-term assets like cash, inventory, and receivables.

The liquidity ratios are near-term focused, which is why current assets and current liabilities are used. The Current Ratio is a quick way to assess a business based on short-term operating conditions. If a company is suspected of having a slower quarter, we can start looking at what obligations there may be. If there are any red flags the ratio can see if they can meet short-term debts should they fall due.

The Current Ratio can be used to answer this question and scenario. “If all the short-term obligations of this business were to fall due today, does it have the capacity and capital to meet that demand”? If the answer is Yes, good, if it is No, we must understand why.

A current ratio can be measured against the industry and other peers. A CR lower than 1 or the industry benchmark can be a sign of financial distress should short-term obligations come due. If a ratio is excessively high, that can be a sign that assets may not be getting maximized, or it is not efficiently using its short-term financing options. If the current liabilities are more than the current assets, the ratio will be less than 1.

A slightly above-industry-average current ratio is ideal for creditors who want to do business with the company. It shows that the business can service and satisfy short-term obligations. For example, a company with a Current Ratio of 2x can cover its short-term liabilities twice if they fall due.

This is why relatively high ratios may not be great, let’s say a CR of 10x. That means this company can cover its short-term liabilities ten times over. There may not be an efficient use of capital or they may be holding a lot of inventory they cannot sell.

Understanding the industry and the business model is very important. We cannot take a ratio and think low is bad and high is good without understanding how the inputs are made up. Companies may have the current ratio affected by areas such as receivables and payables. Certain industries have different payment cycles, one industry may have longer receivables or shorter payables, and these all impact current assets and liabilities.

Knowing the working capital cycle can help determine whether the current ratio is warranted or not. The current ratio is sometimes used as a proxy to govern management’s efficiency to the use of working capital.

What is the Current Ratio formula?

• Current Ratio = Current Assets ÷ Current Liabilities.
• Assets = Found on the balance sheet.
• Liabilities = Found on the balance sheet.

Current Assets: Cash, cash equivalents, marketable securities, accounts receivable and inventory.

Current Liabilities: Accounts Payable, accrued expenses, deferred revenue, Debt due in 12-months.

How to use the CR?

In our first example below, let’s compare 3 companies that are in an industry where the current ratio average is 1.5x. We want to work out the CR and determine which business is in a better position to cover costs.

Current Ratio	Company A	Company B	Company C
Current Assets	$485 million	$738 million	$622 million
Current Liabilities	$562 million	$202 million	$400 million
Current Ratio	0.86x	3.65x	1.55x

In this example we can compare the three companies and see that Company A does not have enough to cover short-term liabilities should they fall due. We would investigate why their liabilities are higher, what is causing the issue and how can the risk be mitigated, if at all. Company C seems to be in line with the industry average looks healthy and can cover the liabilities one and a half times.

Now Company B is high at 3.65x, before we say this is fantastic as it has more short-term assets to cover short-term liabilities, we must assess why it is higher than the industry and its peers. In this case, we would look at the balance sheet over a few years to see how it has been trending and what could be the cause. Let’s take a look at the balance sheet of Company B.

Balance Sheet	2021	2022	2023
Current Assets
Cash	$65 million	$100 million	$102 million
Marketable Securities	$40 million	$42 million	$50 million
Accounts Receivable	$180 million	$190 million	$205 million
Inventory	$192 million	$253 million	$381 million
Total Current Assets	$477 million	$585 million	$738 million
Current Liabilities
Accounts Payable	$90 million	$63 million	$52 million
Short-Term Debt	$190 million	$135 million	$150 million
Total Current Liabilities	$280 million	$198 million	$202 million
Current Ratio	1.70x	2.95x	3.65x

If we were to pull apart the balance sheet we can start to see how the current ratio is ballooning. If we start with the Accounts Payable, it is declining each year, which can mean many things, however with a rise in inventory and a lowering in accounts payable it can be a sign that inventory is building up significantly and not being sold and therefore reordering is slowing down.

We have noticed that the Accounts Receivable is increasing. While this can be a positive sign when compared to an increase in inventory and a decrease in accounts payable, we need to determine whether the increase in receivables is due to more sales or if customers are not paying their dues, which could be contributing to the current assets.

When analysing the Current Ratio, it is important to examine the inputs and observe how they are changing. It is also helpful to compare them with other financial metrics to gain a deeper understanding of the ratio numbers. For instance, if Company B is experiencing growth and sales are increasing, and cash is also rising, then a higher multiple may be justified as the current assets are growing in line with revenue.

The financial statements always provide context to the ratio multiples.

In Summary…

When I use the current ratio, I will look at the balance sheet exactly as I have laid out above. It was quite clear the impacts of COVID-19 towards a lot of companies. I noticed a lot of companies on my watch list had accelerated higher Current Ratios. It was mostly found in companies that held a lot of Inventory especially if they had made large orders before the slowdown.

By investigating further, I was able to see Accounts payable going down dramatically, and inventory rising as they could not move it, so the current assets skyrocketed. This had a major negative effect on working capital. When using liquidity ratios, the working capital cycle is important. What can seem alarming when scanning based on ratios is nothing more than industry practice for certain sectors.

Online retailers that collect money upfront will have very different current ratios to companies that pay for inventory upfront like a manufacturer and then have longer payment terms with their customers. It can create a gap in the current assets and liabilities, but considered general business pracitces.

I always dig deeper into the business cycle and how the business generates its money and pays its suppliers before looking at ratios. I think once you get your head around the business and certain industries you are less prone to judge companies based on a few metrics.

One last consideration is this ratio uses “Current” as the input. Some companies that look like they will struggle to meet short-term debt sometimes can cover these costs as the long-term assets may be significant in proportion. Using alongside the debt-to-equity ratio may be more helpful.