The current ratio measures the ability of an organization to pay its bills in the near-term. It is a common measure of the short-term liquidity of a business. The ratio is used by analysts to determine whether they should invest in or lend money to an entity.
Current assets ÷ Current liabilities
For example, a supplier wants to learn about the financial condition of Lowry Locomotion. The supplier calculates the current ratio of Lowry for the past three years:
|Year 1||Year 2||Year 3|
The sudden rise in current assets over the past two years indicates that Lowry has undergone a rapid expansion of its operations. Of particular concern is the increase in accounts payable in Year 3, which indicates a rapidly deteriorating ability to pay suppliers. Based on this information, the supplier elects to restrict the extension of credit to Lowry.
Since the ratio is current assets divided by current liabilities, the ratio essentially implies that current liabilities can be liquidated to pay for current assets. A current ratio of 2:1 is preferred, with a lower proportion indicating a reduced ability to pay in a timely manner.
The current ratio can yield misleading results under the following circumstances:
- Inventory component. When the current assets figure includes a large proportion of inventory assets, since these assets can be difficult to liquidate. This can be a particular problem if management is using aggressive accounting techniques to apply an unusually large amount of overhead costs to inventory, which further inflates the recorded amount of inventory.
- Paying from debt. When a company is drawing upon its line of credit to pay bills as they come due, which means that the cash balance is near zero. In this case, the current ratio could be fairly low, and yet the presence of a line of credit still allows the business to pay in a timely manner. In this situation, the organization should make its creditors aware of the size of the unused portion of the line of credit, which can be used to pay bills.
- Comparisons across industries. Companies have different financial structures in different industries, so it is not possible to compare the current ratios of companies across industries. Instead, one should confine the use of the current ratio to comparisons within an industry.