What is Current Ratio? Meaning, Formula & Calculator

Do you wish to calculate the Current Ratio of a business? Don't miss out our Current Ratio Calculator that's free to use and embed too! But before that, also learn in detail about Current Ratio, its formula, how it is calculated and much more.

Ratios in finance present a snapshot of business’s position, but over and above that, the most important aspect of financial ratios is in the fact that they’re comparable on any scale. While numbers provide a base, calculation of ratios are the first step towards analytical research. Now, let’s get into it!

What is Current Ratio?

Current ratio represents the current position of the business. That’s it! To simplify it further, let's look at it this way:

Divided by time, any business has majorly two kinds of assets and liabilities.

The first are long term and short term assets. We could go to list long term, or fixed assets like buildings, trademarks, patents, or we could just tell you that any asset that is supposed to be with the business and continue to add value for more than one year are long term assets. There are subdivisions among those as well like fixed, intangible, etc. but who cares?

Let’s talk about the short term assets, the current assets like:

1.Inventory

2.Cash and cash equivalents

3.Accounts receivables

4.Prepaid expenses

5.Marketable securities, etc.

The idea is to think in terms of liquidity. These are the assets that can be liquidated into cash in case of any scenario, which is usually payment of short term liabilities, or current liabilities like payment of portion of long term debt, taxes, accounts payable, etc.

How to Calculate Current Ratio?

In the era of algorithms and satellites, calculation of current ratio is not a challenge. A lot of websites do the calculation for you, and even we have this FREE calculator that you can use. But the real value is in understanding what it is and what it does.

A current ratio tells you in the past one year (and it is important to remember that this calculation is based on past data, we’ll get into why later) how many times the business could have paid its liabilities in such a way that it would have exhausted its current resources.

In terms of calculation, it looks a little a little something like

Current Ratio = (Current Assets)/(Current Liabilities)

To put it in perspective, let’s assume a company MM (no ad, cool movie) Ltd. had to pay a total of 500 USD in form of aforementioned current liabilities. It had a total of 1000 USD in current assets. So that means it could have paid that liability of 5oo USD twice to exhaust the resource of 1000 USD.

Current Ratio = 1000/500 = 2

So, this gives the current ratio to be 2.

When Should be Current Ratio Used?

Now on its face, current ratio looks simple enough, and it is. Except for a few things that should be kept in mind.

The first thing has to do with general usability of financial ratios. Look ratios are awesome, you don’t have to look at huge 10-digit number to analyse the positions, and most of the ratios do analysis for you, and mark the red flags.

But it should be kept in mind that the entire idea of using numbers and ratios is to use past data to make future projections, which means that any ratio does not represent the position of business on the day of calculation, it represents the position as on the day of numbers.

The second is ratios eliminate numbers. For example, another company DD Ltd. has Current assets of 10000 USD and Current liabilities of 5000 USD.

While both Goodfellas and Irishman have their current ratios as 2, they operate at different scales of business; by extension turnover and net worth, which can be misleading.

What is an Ideal Current Ratio?

The general understanding is that ideal current ratio is 2, which means having twice as many current assets as liabilities. That is not always true. We mean it can be true for industries like banking, who have regular need for cash liquidity, but that is exactly the point. Let’s understand like it like this.

As on June 26, 2020, HCL Technologies has a current ratio of 1.62, whereas JSW Steel Ltd. has a current ratio of 0.84. Now HCL clearly seems like a better company, having 0.62 times more assets than liabilities, right?

Nope. Here enter industry averages. Different industries have different cash needs. A company like JSW usually takes huge loans for their businesses, whose payments affect current liabilities, which is perhaps the reason why JSW’s current ratio is close to its industry average of around 1.

Whereas the industry average current ratio of technological companies is around 2, which means HCL is below average in terms of current ratio.

Also, a higher current ratio is not always good. In most cases, it is a signal that the company does not know how to effectively deploy its funds so it’s sitting on them, losing money in fact due to inflation and time value of money.

So in terms of idea current ratio, it should be accounted for industry averages, type of business and operations, etc. But if it’s in your test, the answer is 2.

What is Quick ratio?

Quick ratio, or acid test ratio is a variation of current ratio but it takes all current assets except inventories. Again, the idea is to think in terms of liquidity.

While current assets like accounts receivable and marketable securities have a cash value associated to them, in terms that they can easily be converted into cash, the process of conversion of inventory to cash is a little more complicated. Here applies the goods life cycle. Raw material is converted to finished goods which are converted to sales i.e. cash and accounts receivable. Accounts Receivable is further en-cashed or sold. Which means inventories are not exactly liquid, compared to other current assets.

In terms of formula, it looks similar except

Quick Ratio= (Current Assets-Inventories)/(Current Liabilities)

Again, the minimum acid test ratios of companies should be ideally 1, but it is also obviously subjected to aforementioned factors.

It should always be kept in mind that while math part of such analysis may look simple, the analytical part is not so. A variety of factors affect, well a variety of factors in business.

Some companies may have a high current ratio because they have too much cash. While others may have a greater current ratio due to huge amounts of accounts receivable because they fail to negotiate with their customers, and many because they don’t have a lot of debt. While ratios mark the red flags on a mine field, it is still the analyst who walks through it.

That was all about Current Ratio, its formula and significance. Did you try our Current Ratio Calculator? If you like it, don't forget to embed it on your site or blog. For any queries, do drop in the comment section.