Current Ratio

Current ratio is a liquidity ratio which measures a company's ability to pay its current liabilities with cash generated from its current assets. It is calculated by dividing current assets by current liabilities.

Current assets are assets that are expected to be converted to cash within a normal operating cycle or one year. Examples of current assets include cash and cash equivalents, marketable securities, short-term investments, accounts receivable, short-term portion of notes receivable, inventories and short-term prepayments.

Current liabilities are obligations that require settlement within the normal operating cycle or one year. Examples of current liabilities include accounts payable, salaries and wages payable, current tax payable, sales tax payable, accrued expenses, etc.

Formula

Current ratio is calculated using the following formula:

Current Ratio =Current Assets
Current Liabilities

When a company presents a classified balance sheet (i.e. a balance sheet in which there is a current and non-current categorization), calculating current ratio is simple but if no such classification is available, we need to analyze the balance sheet line items to identify current assets and current liabilities. As the assets and liabilities are listed in the descending order of liquidity, current assets would appear above non-current assets.

Interpretation

Current ratio compares current assets with current liabilities and tells us whether the current assets are enough to settle current liabilities. There is no single good current ratio because ratios are most meaningful when analyzed in the context of the company's industry and its competitors. Some industries for example retail, have typically very high current ratios while others, such as service firms, have relatively low current ratios.

A current ratio of 1 is safe because it means that current assets are more than current liabilities and the company should not face any liquidity problem. A current ratio below 1 means that current liabilities are more than current assets, which may indicate liquidity problems. In general, higher current ratio is better.

Example

Let's calculate and analyze current ratios for The Coca Cola Company (NYSE: KO) and PepsiCo. Inc. (NYSE: PEP) based on the information given below:

20X420X320X2
Coca ColaCurrent assets32,98631,30430,328
Current liabilities32,37427,81127,821
PepsiCoCurrent assets20,66322,20318,720
Current liabilities18,09217,83917,089

All amounts are in USD in million.

Solution

Current Ratio for CocaCola for 20X4
= 32,986 ÷ 32,374
= 1.02

The following table shows current ratios for both companies for all three years:

20X420X320X2
Coca Cola1.021.131.09
PepsiCo1.141.241.10

We see that PepsiCo. has higher current ratios than Coca Cola in each of the three years which means that PepsiCo is in a better position to meet short-term liabilities with short-term assets. However, current ratios for Coca Cola too have stayed above 1 in all periods, which is not bad.

Both companies experienced improvement in liquidity moving from 20X2 to 20X3, however this trend reversed in 20X4.

Limitations of current ratio

A high current ratio is not necessarily good and a low current ratio is not inherently bad. A very high current ratio may indicate existence of idle or underutilized resources in the company. This is because most of the current assets earn low or no return as compared to long-term assets which are much more productive. A very high current ratio may hurt a company’s profitability and efficiency.

Further, two companies may have the same current ratios but vastly different liquidity positions, for example, when one company has a large amount of obsolete inventories. A more meaningful liquidity analysis can be conducted by calculating the quick ratio (also called acid-test ratio) and cash ratio. These ratios remove the illiquid current assets such as prepayments and inventories from the numerator and are a better indicator of very liquid assets.

Other ratios often used to complement current ratio analysis include receivables turnover ratio inventory turnover ratio and cash conversion cycle.

by Irfanullah Jan, ACCA and last modified on

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