Current ratio analysis, along with the acid-test ratio, measures liquidity. Liquidity refers to the ability of the firm to meet its short-term obligations (obligations over the next 12 months) with its current assets (such as cash, marketable securities and inventory). In other words, current ratio analysis allows us to determine the ease with which business can pay its bills as they come due.
A declining current ratio is an indicator of declining liquidity, which usually serves as a warning of potential financial difficulties for the business. Such financial difficulties may even result in bankruptcy. The risk of bankruptcy especially increases if the current ratio falls below 1 (a point at which current assets can no longer cover current liabilities). Current ratio analyses is also sometimes referred to as working capital ratio, real ratio, cash ratio, liquidity ratio and cash asset ratio.
The formula for current ratio analyses is as follows:
Current ratio = Current assets/Current liabilities
Example of current ratio analysis
Assume Dynasties Inc. has current assets of $550,000 and current liabilities of $300,000. The current ratio of the of Dynasties Inc. is calculated as follows:
$550,000/$300,000 = 1.8
Current ratio analyses of the Dynasties Inc. could indicate that the ratio may be too low. However, an acceptable current ratio value varies between industries. Therefore, the result must always be assessed in the context of industry averages as well as to current ratios of leading firms in the industry and the Dynasties own historical current ratio analysis.
Things to note about current ratio analysis
A positive current ratio is a requirement. A current ratio of two is generally advisable. If a company has a current ratio of two, it means that it has current assets which would be able to cover current liabilities at least twice.
Current ratio analyses is similar to the acid test ratio. However, an acid-test ratio differs from current ratio because an acid-test ratio excludes inventory in calculating current assets. Inventory is excluded as it is seen as the least liquid form of current assets. Acid-test ratio shows a better representation of firm’s liquidity for businesses which experience slow conversion of inventories into cash.
It is also important to note that current ratio analyses ignores the timing of how quickly current assets can be converted into cash and how soon current liabilities come due. For example, imagine a situation where the business has a healthy current ratio. However, most of its current assets are in inventory which can only be converted into cash in 2 months time and most of its current liabilities are due within next 30 days. In such a situation, despite a healthy current ratio, a business’s liquidity may be unsatisfactory to meet the short-term commitments of the business.
Lastly, as per above, one should always compare the current ratio analyses of individual firms to industry averages, to obtain a better understanding. There is a large variability of current ratio industry averages between industries. This is because different industries have different operations requirements.