What is the Current Ratio?
How Does the Current Ratio Work?
Current Ratio = Current Assets / Current Liabilities
For an example of how to calculate the current ratio, let's look at the balance sheet for Company XYZ:
Balance Sheet for Company XYZ
Year ending December 31, 2009
Accounts Receivable 500
Total Current Assets 2,000
Accounts Payable 500
Current Long-Term Debt 500
Total Current Liabilities 1,000
Long Term Debt 500
Total Liabilities 1,500
Owners' Equity 500
We can calculate Company XYZ's current ratio as: 2,000 / 1,000 = 2.0
As of the end of 2009, Company XYZ had $2.00 in current assets for every dollar of current liabilities. The company appears to be able to easily service its short-term debt obligations.
Why Does the Current Ratio Matter?
Tracking the current ratio and other liquidity ratios helps an investor assess the health of a company.
A high current ratio indicates that a company is able to meet its short-term obligations. In the example above, if all of XYZ's current liabilities came due on January 1, 2010, XYZ would be able to meet those obligations with cash.
Generally, a low current ratio could suggest problems with inventory management, ineffective or lax standards for collecting receivables, or an excessive cash burn rate. Increases in the current ratio over time may indicate a company is "growing into" its capacity (while a decreasing ratio may indicate the opposite). But remember that big purchases made in preparation for coming growth (or the sale of unnecessary assets) can suddenly and somewhat artificially change a company's current ratio.
A common but often misleading rule of thumb is that a 2:1 ratio means a company is "in good shape." Comparison of current ratios is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.