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 equals current assets divided by current liabilities.

Current assets are assets that are expected to be converted to cash within 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 normal operating cycle or next 12 months. 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

Companies are required by GAAP to classify assets and liabilities into current and non-current on their balance sheets. This simplifies calculation of current ratio for liquidity analysis. All we need to do is to obtain the current assets and current liabilities figures and divide the former by later.

Where a classified balance sheet (i.e. a balance sheet in to which there is a current and non-current categorization) is not available, we need to analyze the balance sheet line items to identify current assets and current liabilities. Assets and liabilities are listed in the descending order of liquidity, i.e. assets appearing at the top are more liquid than assets at the bottom of the balance sheet.

Analysis

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 becuase ratios are most meaningful when analyzed in comparison with the company's competitors.

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.

Current ratios should be analyzed in the context of relevant industry. Some industries for example retail, have very high current ratios. Others, for example service providers such as accounting firms, have relatively low current ratios because their business model is such that they do not have any significant current assets.

Example

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

201420132012
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 2014
= 32,986 ÷ 32,374
= 1.02

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

201420132012
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 2012 to 2013, however this trend reversed in 2014.

Limitation of Current Ratio

A rising current ratio is not necessarily a good thing and a falling 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 do not earn any return or earn a very low return as compared to long-term assets. A very high current ratio may hurt a company’s profitability and efficiency.

Further, t is quite possible for two companies to have same current ratios but vastly different liquidity position for example when one company has a large amount of obsolete inventories. A more meaningful liquidity analysis can be conducted by calculating 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

Join Discussions

XPLAIND.com is a free educational website; of students, by students, and for students. You are welcome to learn a range of topics from accounting, economics, finance and more. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect!

Copyright © 2010-2019 XPLAIND.com