Current Ratio Analysis
🎯 Learning Objectives
- Understand current ratio formula and its interpretation
- Calculate current ratio and analyze liquidity
- Distinguish between liquidity and profitability
- Identify factors affecting current ratio and working capital
- Apply current ratio analysis to business decision-making
📚 Background & Principles
Current ratio measures a company's ability to pay short-term obligations. It's a key liquidity indicator used by creditors, investors, and management.
The formula is simple, but interpreting it requires understanding business context, industry norms, and trends over time.
🔑 Key Concepts
Current Assets divided by Current Liabilities. Measures ability to cover short-term obligations. Formula: Current Assets ÷ Current Liabilities.
Cash, accounts receivable, inventory, supplies, prepaid expenses, short-term investments. Expected to be converted to cash within one year.
Accounts payable, wages payable, taxes payable, short-term notes payable, unearned revenue. Due within one year or normal operating cycle.
Current Assets minus Current Liabilities. Liquid resources available for operations after paying short-term debts. Formula: Current Assets - Current Liabilities.
How quickly assets can be converted to cash without loss of value. Current assets are generally more liquid than non-current assets.
(Current Assets - Inventory) ÷ Current Liabilities. More rigorous measure of liquidity by excluding inventory.
🔍 Deep Dive
Explore current ratio analysis at different levels of depth:
🟢 Foundational Level
Understanding basic current ratio formula and interpretation.
Can We Make it to Lunch?
Analogy: The Survival Backpack
Imagine you are hiking.
You know you will get hungry in 3 hours.
Do you have enough snacks (Cash, Supplies) in your bag?
Current Assets ÷ Current Liabilities. If you have 2 snacks for every hunger pang (Ratio of 2.0), you are safe.
Ratio of 2.0 means 2x what you need. Good liquidity buffer.
The Current Ratio Formula
🟡 Standard Level
Understanding working capital and acid test ratio.
Working Capital: The Net Liquid Assets
Working Capital = Current Assets - Current Liabilities. This represents the liquid resources available for day-to-day operations.
Current Ratio = (Current Assets) ÷ (Current Liabilities). Can also be expressed as Working Capital ÷ Current Liabilities.
Current Assets: $150,000, Current Liabilities: $100,000
Current Ratio: 150,000 ÷ 100,000 = 1.50
Working Capital: 150,000 - 100,000 = $50,000
Working Capital as Ratio of Liabilities: 50,000 ÷ 100,000 = 0.50
The Acid Test Ratio
A more rigorous measure of liquidity that excludes inventory from current assets.
Acid Test Ratio = (Current Assets - Inventory) ÷ Current Liabilities
Inventory may be difficult to convert quickly or may be obsolete. Acid test shows ability to pay obligations without relying on inventory sales.
🔴 Advanced Level
Complex ratio analysis and strategic interpretation.
Component Analysis
Understanding how individual components of current ratio affect the overall measure.
Company A has Current Assets: $200,000, Current Liabilities: $100,000. Current Ratio: 2.0
Company B has Current Assets: $200,000, Current Liabilities: $50,000. Current Ratio: 4.0
Company A has higher ratio but same absolute current liabilities. Company B has lower ratio but fewer liabilities. Both have same dollar of working capital ($100,000).
Conclusion: Company B is more liquid and has stronger ability to meet obligations despite lower current ratio.
Seasonal Considerations
Current ratios can fluctuate due to seasonal business patterns.
Retailers often have low current ratios after holidays (high inventory, high cash).
Analyze ratios across multiple periods rather than relying on single point. Look for patterns and business cycle impact.
🎨 Interactive Ratio Calculator
A ratio below 1.0 may indicate liquidity problems. Calculate current ratio and working capital.
Current Ratio
Working Capital
Analysis:
Current Ratio of 1.50 indicates good liquidity position. You have 1.5x more in current assets than current liabilities.
Working Capital of $5,000 provides comfortable cushion for operations.
🚫 Common Misconceptions & Professional Tips
✅ Reality: Higher current ratios may indicate inefficient use of current assets (excess cash, slow inventory turnover). The optimal ratio depends on industry, business model, and seasonality.
✅ Reality: Ideal ratios vary by industry. Retail may function well at 1.5, while technology companies may be fine at 1.0-1.2. Focus on industry benchmarks rather than arbitrary thresholds.
✅ Reality: While adequate working capital is essential, having too much can indicate poor cash management. Balance liquidity needs with profitability and return on investment.
🧠 Memory Aids & Quick Reference
Current Ratio = Current Assets ÷ Current Liabilities
Working Capital = Current Assets - Current Liabilities
Acid Test Ratio = (Current Assets - Inventory) ÷ Current Liabilities
Indicates strong liquidity. May signal excess current assets or conservative working capital management.
Generally considered healthy. Adequate working capital for most operations.
May indicate liquidity problems. Need careful cash flow management or external financing.
More working capital than current liabilities. Strong ability to meet obligations and fund growth.
Current liabilities exceed current assets. May indicate operational difficulties or financing needs.
📖 Glossary
Current Assets divided by Current Liabilities. Measures liquidity and ability to meet short-term obligations.
Cash, accounts receivable, inventory, supplies, prepaid expenses, short-term investments. Assets expected to be converted to cash within one year.
Accounts payable, wages payable, taxes payable, short-term notes payable, unearned revenue. Obligations due within one year or normal operating cycle.
Current Assets minus Current Liabilities. Liquid resources available for operations after paying short-term debts.
How quickly assets can be converted to cash without loss of value. Current assets are generally more liquid than non-current assets.
(Current Assets - Inventory) ÷ Current Liabilities. More rigorous measure of liquidity by excluding inventory.
Time from purchasing inventory to selling and collecting accounts receivable. Affects working capital needs.
Current Assets minus Inventory divided by Current Liabilities. Alternative to acid test ratio.
Ability to meet both short-term and long-term obligations. High current ratios support short-term solvency, but long-term solvency depends on overall financial structure.
🎯 Final Knowledge Check
Test your understanding of Current Ratio Analysis:
Question 1: A company has Current Assets of $200,000 and Current Liabilities of $100,000. What is the current ratio?
Question 2: What does a current ratio of 2.0 indicate?
Question 3: Working Capital is calculated as: