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The current ratio measures how much of its short-term(cash, inventory and receivables) a company would need to use to pay back its short-term liabilities (debts and payables).
How to calculate current ratio
Current ratio is calculated by dividing a company's current assets by its current liabilities:
Current ratio = Current assets/liabilities
For example, a company with total debt and other liabilities of £2 million and total assets of £5 million would have a current ratio of 2.5. This means its total assets would pay off its liabilities 2.5 times.
It tells you how financially strong a company is but also how efficiently it is investing its assets and is sometimes referred to as the liquidity ratio or cash asset ratio.
A high current ratio above 1.5 is considered healthy
A ratio of around 1.5 is generally considered solid and should support a company's share price.
What is considered acceptable will differ, however, depending on what sector a company operates in, how liquid its assets are, how easily it is able to refinance debt and how it plans to use any excess assets.
We show you how to determine this in the following lessons.
A current ratio of 1 or below suggests a company may struggle
A ratio of around 1 or below suggests that the company might struggle to pay off its debts and other liabilities.
This makes the company a riskier. Its shares may become less attractive to , fearful that bankruptcy could wipe out their investment, and this could push its share down.
You would need to look more deeply into that company's finances at this stage to determine if it has liquidity issues, such as difficulty being paid on time by its own customers.
Also, try and find out how easily it would be able to refinance any debt. If it can replace existing debt with new, longer-term debt, its low current ratio will probably exert less downward pressure on its share price, at least in the short term.
A ratio of less than 1.5 is also less of a problem if the company's assets are very liquid, meaning they can be converted into cash very quickly.
At the other extreme, a current ratio of 3 or 4 may signal financial strength, but it also raises concerns that a company is inefficient at investing what cash it has.
If this is the case, try and find out if the company has important plans for its cash pile – for example making acquisitions – that might justify it and could increase its growth potential.
So far you have learned that...
- … the current ratio is a calculation that measures how much of its short-term assets a company would need to use to pay back its short-term liabilities.
- … a current ratio of 1.5 or above is considered healthy, while a ratio of 1 or below suggests the company would struggle to pay its liabilities and might go bankrupt.
- … a ratio of 1.5 or higher suggests a company can comfortably manage its borrowing costs but this is more or less important depending on how consistent a company's earnings are.
- ... a ratio of over 3 or 4 may signal strength, but may also cause concern that the company is inefficient at investing the cash it has.
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