Guide to Current Ratio: How to Calculate Current Ratio

A current ratio is a measurement that gauges a company's ability to pay off short-term obligations within a year. The current ratio, also known as the working capital ratio, is a liquidity ratio in which a company's total current assets are weighed against its current liabilities. These items are listed on a company’s balance sheet, in order to track money coming in against money going out.

Different industries have different standards for “current ratios,” but a current ratio of 1.0 indicates that a company’s current assets can cover the cost of its liabilities. Anything above 1.0 indicates that a company should be financially solvent for a given year.

The current ratio works by measuring a company's total current assets against its current liabilities. Relevant assets considered on the company's balance sheet include cash and cash equivalents, inventory, property, and accounts receivable. Current liabilities include short-term debts, wages, accounts payable, taxes payable, and the portion of long-term debt due within the year.

A current ratio of 1.0 indicates that a company's current assets are equal to its current liabilities. The average current ratio varies from industry to industry, but is typically somewhere between 1.0 and 3.0.

The current ratio formula is: Current ratio = Current Assets / Current Liabilities. Assets include cash, inventory, property, and accounts receivable. Liabilities include debts, wages, accounts payable, and taxes payable, and current long-term liabilities. A low current ratio (below 1.0) indicates that a company is not in a position to cover its short-term liabilities, whereas a high current ratio with a number of 3.0 says that a company could cover its current financial obligations 3 times over.

Calculating a company’s current ratio is the simplest and most common way of measuring its liquidity. However, there may be some limitations to using the current ratio when comparing companies between or within industries.

1. 1. Certain assets and liabilities can get lost. The current ratio equation simply compares a company’s assets against its liabilities, so the nuances of different types of assets and liabilities can get lost. For example, some liabilities may be easier to pay off than others while some assets (like real estate) may be harder to liquidate.
2. 2. The current ratio disregards credit. One thing the current ratio fails to consider is how credit is extended for different businesses. One industry may be more likely to receive extended credit than another, giving the impression of more short-term security.
3. 3. Assets do not always mean liquidity. Any assets that are difficult to liquidate can complicate the current ratio. For example, a company may have a high amount of assets in inventory, but that doesn’t mean that the inventory can be easily liquidated and turned into cash to cover its liabilities. A company with fewer total assets may be in a better position with more of its assets in cash or other assets that can be easily liquidated.

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