15. What is a Good Current Ratio? With Examples

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What is a Good Current Ratio? With Examples

Apr 21, 2023 • 7 min read

The current ratio is a financial ratio that is calculated by dividing a company’s current assets by its current liabilities.

Current assets consist of cash and assets like accounts receivable and inventory that a business expects to convert to cash within the next year. On the other hand, current liabilities are liabilities like accounts payable and accrued compensation that a business expects to pay off within the next year. By determining how these two compare, the current ratio serves as a rough, at-a-glance indicator of a company’s short-term liquidity at a particular moment in time.

How to calculate current ratio.

The current ratio can be summarized with this formula:

Current Assets / Current Liabilities = Current Ratio

Current ratio example.

For example, let’s say that your business’s balance sheet looks like this:

The first step in calculating your current ratio is identifying which of your assets are current assets and which of your liabilities are current liabilities.

Of your assets, cash and cash equivalents, accounts receivable, and inventory are all current assets:

• Cash of \$100,000 is a current asset because it is ready to be used immediately.
• Accounts receivable of \$200,000 is a current asset because it represents amounts owed to your business from its customers—amounts you will be paid within the next year.
• Inventory of \$300,000 is a current asset because your business intends to sell it within the next year.

These current assets total \$600,000.

Property, plant, and equipment is not a current asset because you do not intend to sell them within the next year.

Of your liabilities, accounts payable, accrued salaries, income taxes payable, and short-term loans payable are all current liabilities:

• Accounts payable of \$250,000 is a current liability because it represents amounts you owe to your vendors—amounts you will pay within the next year.
• Accrued salaries of \$10,000 is a current liability because it represents wages that your employees have earned, but haven’t yet been paid but will be paid on your business’ next payday.
• Income taxes payable of \$25,000 is a current liability because your business will pay its income taxes due within the next year.
• Short-term loans payable of \$15,000 is a current liability by definition; loans should only be classified to this account if they mature within the next year.

These current liabilities total \$300,000.

Long-term debt is not a current liability because it’s “long term,” meaning that it will be paid off in more than a year from now.

What is a good current ratio?

Although industry standards vary, it’s generally safe to say that a company’s current ratio should be at the very least 1.0.  A current ratio of less than 1.0 indicates that a company’s short-term assets, even if fully realized at their book value, would not be able to cover its short-term liabilities. This is to say that a current ratio of less than 1.0 is generally a bad current ratio.

This isn’t to say, however, that a current ratio of 1.0 is necessarily good. Remember, not all current assets on a business’ balance sheet will be realizable at book value. For example, not all accounts receivable may actually be collected. Also, being able to barely cover all of a business’ current liabilities with its current assets, with nothing left over, isn’t exactly an indicator of a healthy business.

For these reasons, companies in most industries should consider a ratio between 1.5 and 2.0 as a “good” current ratio. A current ratio in this range signals that there is little concern about the company being able to keep up with its short-term obligations.

That said, a current ratio could be too high. If a current ratio is approaching 3.0 or greater, this could be an indication that the company is not deploying cash to invest in further business growth, resulting in stagnation.

Limitations of the current ratio.

Like all financial ratios, the current ratio is a quick, easy-to-calculate ratio that could alert business owners to financial issues in their company, but should never be taken as a definitive measure of a company’s financial health.

One major limitation of the current ratio is that it is calculated at a specific moment in time and does not take into account transactions in the near future that could significantly affect the company’s current assets and liabilities. A significant cash infusion next week, for example, could result in a much higher current ratio at that moment in time than at present.

Another limitation of the current ratio is that it treats all current assets equally, even though not all current assets could be easily converted to cash—or converted at all—in the event of a liquidity crisis.

For example, some receivables included in the current ratio may never be collected, such as if a customer who purchased something from your company on credit goes out of business.

It’s a similar story for inventory—some of a company’s inventory may be very slow to sell or may never sell at all.

In fact, if your company has significant inventory balances, you may want to use the acid test ratio alongside the current ratio in evaluating your company’s short-term liquidity.

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