What is Current ratio?
Understanding the current ratio formula is an important element of liquidity ratio analysis.
Liquidity ratios help us in understanding if the companies are in a better position to meet their short-term obligations.
One of the most widely used and important liquidity ratio is the Current Ratio.
Not only the ratio is very simple to calculate, but also highlights the overall liquidity position of the company clearly.
Hence, the current ratio is often used by investors and lenders. This helps them in evaluating the company better.
Current ratio meaning
The current ratio basically means how much current assets does the company have as against current liabilities.
This helps in understanding if the company has sufficient resources to meet its short-term obligations.
Ideally, the company is expected to have high current Assets relative to Current liabilities. This boosts the overall liquidity position of the company.
Current ratio formula
The formula for the current ratio is closely related to the Working Capital formula.
We take Current Assets in the numerator and Current Liabilities in the denominator.
Both the values can be obtained from the Balance Sheet.
Current assets basically refer to the cash and other assets of the company which are expected to be utilized within the current operating cycle.
Similarly, Current Liabilities refer to the obligations that the company is expected to fulfill within the current operating period. This generally includes payment due to suppliers and other accrued expenses.
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Current ratio formula example
Let us understand the current ratio formula using a simple example.
Consider the below-given companies- Company A and Company B.
The values given below are in USD millions.
We are given the Balance Sheet extract for both the companies through which we can calculate the current ratio easily.
To calculate the current ratio we need current assets and current liability. Let us calculate the current asset for both the companies.
In the above example, let us add all the current assets
- Cash and cash equivalent
- Marketable securities
- Prepaid expenses.
Similarly, let us add all the current liabilities. In the given example we have only three current liabilities.
- Accounts payable
- Short term loan
- Other short term liabilities
When we add all the current assets and current liabilities for the respective companies we get below values.
- Current assets = $560
- Current liabilities =$220
- Current assets = $620
- Current liabilities =$800
Calculating the current ratio.
Current ratio = Current assets / Current Liabilities
Company A =$ 1,560/ $220 = 2.54 times
Company B = $620/ $800 = .075 times
Hence, the current ratio for Company A is 2.5 times while Company B is only 0.75 times.
What this indicates is that for each dollar of current liabilities, Company A has $2.5 of Current Assets.
This shows Company A has sufficient current assets to pay off its current liabilities.
On the contrary, Company B has insufficient current assets to pay off its current liabilities. Hence, the ratio is less than 1.
Ideally, it is preferred to have a current ratio which is greater than 1. This makes sure that the company has sufficient current assets to pay off its current liabilities
How to calculate Current ratio using excel
To understand the practical application of the ratio, let us calculate the current ratio for Walmart in excel.
You can download the current ratio template for Walmart using the below option.
After you download the template you will see the consolidated Balance Sheet of Walmart and related calculation using excel.
Below given is the Balance Sheet extract showing total assets of Walmart.
When we add all the current assets like Cash and cash equivalent, Receivables, Inventories, Prepaid expenses and Other current assets we get the total value of $61,897.
Now, consider the below-given Balance Sheet extract showing Equity and liabilities.
Similar to above, we add items like Accounts payable, Accrued expenses, Short term debt, Lease obligations & other current liabilities. We get a total value of $77,477.
Now that we have all the values required we can calculate the current ratio.
Current ratio=Current Assets / Current Liabilities
Current ratio= $ 61,897/$ 77,477 = 0.8 times
As calculated above, the current ratio for Walmart is 0.8 times.
This means that for each dollar of current liabilities, Walmart has only $0.8 worth of current assets.
Ideally, the current ratio should be more than 1. But, in the case of Walmart, it is only 0.8 which is not a good sign.
Before concluding based on a single period, the ratio needs to be analyzed historically.
Also, it is equally important to see how different is the ratio for other companies in the same sector.
This helps in understanding if the low current ratio is only a company-specific scenario or an industry-wide phenomenon.
Current Ratio interpretation
As already highlighted, the Current ratio indicates how much current assets does the company have for each dollar of current liability.
Current ratio less than 1
- If the current ratio is less than 1, this indicates that the company does not have sufficient current assets against its current liabilities.
- This also indicates that the company may have insufficient Cash or Inventory balance to pay off its current liabilities.
- If the ratio deteriorates further, the company may have to tap other non-current assets like Investments so that it can raise money to meet its short term obligations.
Current ratio greater than 1
- On the contrary, if the current ratio is more than 1, this indicates that the current assets of the company are sufficient to meet its current liabilities.
- This improves the overall liquidity position of the company.
- At the same time, if the company has a very high current ratio (say more than 3 times), it is not always good.
- This may show that the company may be finding it difficult to collect money from its customers leading to unusually higher Receivable balance.
- Calculating days sales outstanding and receivable turnover ratio will be helpful in managing the Receivable balance more efficiently.
- Also, due to inefficient Inventory management, the company’s inventory gets piled up significantly leading to higher current assets.
- Increasing inventory will be a drag on the overall liquidity of the company.
- Hence, calculating the Inventory turnover ratio or Days Inventory on hand will help identify the issue and resolve the issue.
Any financial ratio should always be analyzed historically.
Trend analysis of financial ratios is an integral part of ratio analysis.
Below is the Trend Analysis of the current ratio for Tesla, a US-based automobile company predominantly manufacturing electronic vehicles.
As evident in the chart above, back in 2014, the Current Assets > Current Liabilities.
Hence, the Current Ratio was great than 1.
But, as we move forward to 2018, we can see that the situation has reversed.
Now, Current liabilities > Current Assets.
Hence, the Current Ratio has fallen to less than 1.
The current portion of the long term borrowing will be part of Current Liabilities.
Hence, in the case of Tesla, the current liabilities increased significantly compared to current assets.
So, as evident from the chart above, for the past 4 years, the current ratio has been falling.
Currently, the current ratio for Tesla is 0.83 times.
Comparison with similar companies
Apart from performing Trend Analysis, it is equally important to understand how different are the ratios in other sectors.
This helps in understanding the industry dynamics.
Walmart vs Home Depot
Let us look at the ratio profile for companies like Walmart and Home Depot.
Generally, due to the tight working capital requirement, companies in the retail sector have a very low current ratio in the range of 0.5 to 1 times.
In the case of Walmart, as we can see in the chart above the current ratio has decreased for the past 5 years.
Currently, the current ratio for Walmart is 0.8 times.
Now, let us look at Home Depot- a home improvement retailer (supplies tools, construction products, and various similar services).
Although not an accurate comparison, we can see that the current ratio is slightly better than Walmart.
Yet, even in the case of the Home Depot, the ratio has been decreasing for the past 5 years.
Currently, the current ratio for Home Depot is 1.1 times.
In the case of Amazon, we can see the current ratio is in the same range of 0.9 to 1.1 times.
Although the ratio has not increased, the company is able to maintain a steady current ratio.
Unlike Walmart and Home Depot, this indicates better liquidity management by the company.
Currently, the current ratio for Amazon is 1.1 times
The current ratio is no different when we take companies in the Oil & Gas sector.
In the case of Exxon Mobil- a US-based multinational oil and gas company, the current ratio is in the range of 0.5 to 1 times.
Even Exxon Mobil is unable to improve the liquidity position.
Currently, the current ratio for ExxonMobil is 0.8 times.
Facebook vs Google vs Microsoft
Apart from the retail sector, if you look at the current ratio profile for tech-based companies, we can observe that the ratio values are higher relative to the retail sector companies.
In our next examples, we will look at the current ratio profile for companies like Facebook, Google and Microsoft.
As evident from the chart above, in the case of Facebook, the current ratio was as high as 13 times. This is because of lower current liabilities relative to current assets.
Generally, these companies generate sufficient cash to paying off their dues to suppliers.
Hence, the current ratio tends to be relatively higher.
Over the past 4 years, the company was able to manage its liquidity requirements most efficiently. As a result of which the current ratio increased from 9 times to 13 times.
But, as evident in the chart above, recently the ratio has fallen. This drastic fall in the ratio is mainly because of the considerable increase in its current liabilities.
Currently, the current ratio for Facebook is 7.2 times, which is far better than other companies under the discussion.
As we move to Google, we can see that the ratio is in the range of 3 times to 6 times.
Clearly, its evident that the company is unable to increase the ratio.
Nonetheless, it is able to avoid any volatility in the ratio which can be attributed to sustainable liquidity management.
Currently, the current ratio for Google is 3.9 times
Now, let us at Microsoft. The ratio is relatively lower when compared with companies like Facebook and Google.
Owing to a tight working capital requirement, the company is unable to increase its current ratio. Yet, it has maintained a steady-state current ratio which is in the range of 1.5 times to 3 times.
For the year ending 30 June 2019, the current ratio for Microsoft is 2.5 times.
How to improve current ratio?
Now, let us look at the Current Ratio formula once again.
Current Ratio = Current Assets / Current Liabilities.
We can now understand the various ways through which we can improve the current ratio.
Better receivable management
- Generally, Receivables are the big chunk of Current Assets. Hence, it is important to track and maintain a healthy receivable balance.
- Increasing receivable balance may indicate the difficulty in collecting the money from customers.
- A timely collection of dues from the customers will often lead to better liquidity.
- It is also important to pay attention to the Inventory balance. Any inefficient inventory management will lead to liquidity constraints since cash is blocked in inventory for a prolonged period.
- Financial metrics like Inventory turnover ratio and Days Inventory on hand has to be analyzed periodically.
Payment to suppliers
- Payment towards suppliers has to be made considering the working capital requirement. If feasible, the payment period should be extended such that it helps in a better liquidity position.
- If the company has taken a loan as part of its operations, the balance due appear on the Balance Sheet as a liability.
- Generally, the current portion of long term borrowings is reflected in the current liabilities.
- Hence, better payment terms should be negotiated from the borrower such that it does not drain the liquidity of the company.
Scroll through below recommended resources or learn other important Liquidity ratios.
- Interest coverage ratio formula
- Operating Profit margin formula
- Debtor turnover ratio
- Debtor Days formula
- Defensive Interval Ratio