Current Ratio's Definition and Significance

In the world of finance, liquidity is one of the most crucial aspects of a company's ability to survive and thrive. Without sufficient liquidity, even the most promising businesses can quickly find themselves in financial trouble. One of the key tools used by analysts, investors, and creditors to assess a company's liquidity is the current ratio. This simple yet powerful metric offers a quick snapshot of a company's ability to cover its short-term liabilities with its short-term assets.

To fully appreciate its importance, it's essential to explore this ratio's definition, calculation, what constitutes a "good" current ratio, and how it compares to another liquidity measure—working capital.

Current Ratio's Definition and Calculation

At its core, the current ratio is a measure of a company's ability to pay off its short-term obligations (i.e., debts or liabilities) with its short-term assets (i.e., assets that are expected to be converted into cash or consumed within a year). In essence, it answers the question: "Does this company have enough short-term assets to cover its short-term debts?"

The formula for the current ratio is:

Current Ratio=Current Assets/Current Liabilities

Where:

Current assets include cash, accounts receivable, inventory, and other assets that are expected to be liquidated within the next 12 months.

Current liabilities are debts that must be paid within the same period, including accounts payable, short-term debt, and accrued expenses.

For example, according to Apple's latest financial reports, it has $152.99 billion in current assets and $176.39 billion in current liabilities. Using the formula, we get:

Current Ratio= $152.99 billion/176.39 billion=0.87

Basically, A current ratio below 1 can signal liquidity issues. This may indicate that the company is relying too heavily on short-term borrowing or struggling to convert assets into cash quickly enough to cover liabilities.  However, a low ratio doesn't necessarily signal an immediate crisis. If Apple has strong long-term growth potential, it could leverage those prospects to secure financing and cover its current obligations.

What is a Good Current Ratio?

"A good current ratio is really determined by industry type, but in most cases, a current ratio between 1.5 and 3 is acceptable," says Ben Richmond, US country manager at Xero. This means that the value of a company's assets is 1.5 to 3 times the amount of its current liabilities.

The ratio within this range suggests that the company has sufficient short-term assets to cover its immediate obligations, while still maintaining a healthy balance between liquidity and asset utilisation.

However, it's important to note that what constitutes a "good" current ratio can differ across industries. For instance, companies in capital-intensive sectors like manufacturing or automotive typically operate with lower ratios, as they often rely on long-term financing and have higher levels of inventory.

Ford has a current ratio of around 1.2. which is relatively low compared to companies in other sectors. This is common in the automotive industry, where high inventory and long production cycles mean companies rely on other forms of financing, like debt or longer-term credit, rather than holding high levels of liquid assets.

Conversely, service-oriented businesses with minimal physical assets may tend to have higher ratios due to fewer long-term obligations. Microsoft, for example, boasts a current ratio of approximately 2.5. As a software company, Microsoft has low inventory costs and fewer short-term liabilities, allowing it to maintain a stronger liquidity cushion without the need for significant long-term debt.

A ratio significantly above 3 could indicate that the company is hoarding too much cash or other liquid assets, rather than using them for reinvestment or growth opportunities.

For instance, in the chart below, we could see Facebook used to have a current ratio above 3.0. which peaked at 12.916 in 2017. This could suggest that the company has substantial liquid assets.

While this might sound positive, it could also mean that Meta is not effectively utilising its funds to generate growth or shareholder returns, potentially missing out on opportunities to reinvest its cash. In a fast-paced industry, the underutilisation of resources could potentially lead to lower returns on equity or inefficient capital management.

From a lender's perspective, a very high current ratio might signal risk, suggesting the company may not be effectively deploying its cash to generate returns or that it's too conservative with its financial management. Lenders may question why the company has so much cash on hand rather than using it for growth initiatives, which could be seen as a sign of stagnation.

On the other hand, a ratio lower than 1 suggests that the company might struggle to meet its short-term debts, which could signal financial distress if not carefully managed.

J.C. Penney, a well-known American department store chain, which, at its peak, operated hundreds of stores across the United States. Before its bankruptcy proceedings it had a current ratio of 0.7. This meant that the company had insufficient liquid assets to cover its short-term liabilities, and it faced difficulties in fulfilling its immediate obligations.

In such cases, a low current ratio could be an early indicator of liquidity problems, signalling the need for a closer look at the company's financial health and possibly external support or restructuring.

In summary, a "good" current ratio varies by industry and the specific circumstances of a company, but generally, a ratio between 1.5 and 3 is considered healthy. This range typically indicates that a company has sufficient short-term assets to cover its current liabilities, providing a cushion against financial instability. However, context is key; companies in capital-intensive sectors like manufacturing or automotive might operate effectively with lower ratios, while service-oriented businesses could maintain higher ratios without difficulty.

Current Ratio vs. Working Capital

While the current ratio offers a snapshot of liquidity, another important metric for assessing financial health is working capital. Working capital is the absolute dollar amount of resources available to finance a company's day-to-day operations and meet short-term liabilities.

The formula for working capital is:

Working Capital=Current Assets−Current Liabilities

For beginners, understanding the difference between working capital and current ratio can be quite tricky, especially since both terms are based on the same balance sheet items to assess a company's liquidity. To clarify the distinction between the two, let's walk through a simple example.

Imagine Miss Jena is the owner of Jenna's Collections. At the end of her first year in business, she wants to evaluate the company's liquidity. Here's what her balance sheet looks like:

Using the figures from this balance sheet, we can calculate both working capital and the current ratio. First, let's look at working capital. The formula for calculating working capital is straightforward: subtract current liabilities from current assets. In this case, Jenna's total current assets amount to $55.000. while her current liabilities total $45.000. So, her working capital would be $10.000 ($55.000 – $45.000). This means that after paying all short-term obligations, Jenna's Collections has $10.000 left in its short-term capital. This suggests a healthy financial position with a low level of risk.

Now, let's move on to the current ratio. This ratio is also easy to calculate, following a similar process. Simply divide total current assets by total current liabilities. For Jenna's Collections, the ratio would be 1.2 ($55.000 ÷ $45.000). This ratio, being greater than 1. indicates that the company has $1.20 in current assets to cover every $1 of current liabilities. This further reinforces the company's stable financial position.

While both current ratio and working capital are derived from similar balance sheet figures, their application and the insights they offer to investors differ significantly.

Current Ratio is primarily used by investors to assess a company's short-term liquidity and its ability to meet immediate financial obligations. It's especially useful when an investor wants to quickly understand whether the company can cover its current liabilities with its current assets.

As is analysed above, a current ratio greater than 1 generally indicates that the company is in a strong position to handle its short-term debts, whereas a ratio below 1 could signal potential liquidity problems. For instance, if an investor is considering the risk of a company's solvency in the short term or its ability to avoid default, this ratio provides a clear and immediate picture.

On the other hand, working capital is a broader indicator, often more relevant for long-term investors who are interested in a company's overall financial health and stability. It represents the difference between a company's current assets and current liabilities, providing a snapshot of how much capital is available to fund its daily operations and cover short-term debts.

For investors focused on the company's operational efficiency and long-term growth potential, working capital is a useful metric. It reflects whether the company has enough resources to fund its day-to-day activities without the need to rely on external financing.

While the current ratio gives an investor a quick, quantitative snapshot of a company's liquidity, working capital gives a more comprehensive view of the company's operational financial health. In practice, investors might use the ratio to quickly gauge a company's liquidity position, especially when assessing risk or considering short-term investment strategies. Working capital, however, is more beneficial when investors are looking at a company's ability to sustain growth and manage its operations efficiently over time.

In summary, the current ratio is ideal for assessing short-term financial stability, while working capital provides deeper insights into a company's operational efficiency and its capacity to meet both short-term and long-term financial goals.

Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.