## What Is Current Ratio?

The current ratio is a commonly-used financial ratio. It tells investors and analysts whether a company is able to pay its current liabilities with its current assets (typically within a 12-month period).

## Current Ratio Formula

To calculate current ratio, you’ll need the firm’s balance sheet and the following formula:

## Current Ratio Example

Let's look at the balance sheet for Company XYZ:

We can calculate Company XYZ's current ratio as: 2,000 / 1,000 = 2.0

At the end of 2020, Company XYZ had $2.00 in current assets for every dollar of current liabilities. This means that Company XYZ should easily be able to cover its short-term debt obligations.

## What Does a Higher Current Ratio Mean?

A company with a current ratio of between 1.2 and 2 is typically considered good. The higher the current ratio, the more liquid a company is. However, if the current ratio is too high (i.e. above 2), it might be that the company is unable to use its current assets efficiently.

A higher current ratio indicates that a company is able to meet its short-term obligations. In the example above, if all of Company XYZ's current liabilities were due on January 1, 2021, the firm would be able to meet those obligations with cash.

## What Does a Current Ratio Increase Mean?

An increase in current ratio can mean a company is 'growing into' its capacity.

It’s important to remember, however, that major purchases that prepare for upcoming growth – or the sale of unnecessary assets – can suddenly and somewhat artificially change a company's current ratio.

### What Does a Decreasing Current Ratio Indicate?

Generally, a decrease in current ratio means that there are problems with inventory management, ineffective or lax standards for collecting receivables, or an excessive cash burn rate.

If a company’s current ratio falls below 1, the company likely won’t have enough liquid assets to pay off its liabilities. While a decreasing current ratio indicates poor financial health, it doesn’t necessarily mean that the company will fail.

## Why Is Current Ratio Important?

Tracking the current ratio and other liquidity ratios helps an investor assess the health of a company. More specifically, investors will understand how the company is able to cover its short-term debts (compared to its industry competitors).

### Comparing Current Ratios Between Industries

Comparison of current ratios is generally most meaningful among companies within the same industry. Therefore, the definition of a 'high' or 'low' ratio should be made within this context.

For example, if Company XYZ is a retail company, it would only make sense to compare its current ratio with other retail companies (not a construction company).