Current Ratio

What it is:

The current ratio is the ratio of current assets to current liabilities.

How it works/Example:

The current ratio is a commonly used liquidity ratio that measures a company's ability to pay its current liabilities with its current assets.

Current Ratio = Current Assets  / Current Liabilities

For an example of how to calculate the current ratio, let's look at the balance sheet for Company XYZ:

Balance Sheet for Company XYZ
   Year ending December 31, 2009

Assets    
Cash                                       1,000
Accounts Receivable                  500
Inventory                                    500
Total Current Assets               2,000

Liabilities  
Accounts Payable                      500
Current Long-Term Debt           500
Total Current Liabilities          1,000

Long Term Debt                        500
Total Liabilities                       1,500

Owners' Equity                          500

We can calculate Company XYZ's current ratio as:  2,000 / 1,000 = 2.0

As of the end of 2009, Company XYZ had $2.00 in current assets for every dollar of current liabilities. The company appears to be able to easily service its short-term debt obligations.

Why it Matters:

Tracking the current ratio and other liquidity ratios helps an investor assess the health of a company.

A high current ratio indicates that a company is able to meet its short-term obligations. In the example above, if all of XYZ's current liabilities came due on January 1, 2010, XYZ would be able to meet those obligations with cash.

Generally, a low current ratio could suggest problems with inventory management, ineffective or lax standards for collecting receivables, or an excessive cash burn rate. Increases in the current ratio over time may indicate a company is "growing into" its capacity (while a decreasing ratio may indicate the opposite). But remember that big purchases made in preparation for coming growth (or the sale of unnecessary assets) can suddenly and somewhat artificially change a company's current ratio.

A common but often misleading rule of thumb is that a 2:1 ratio means a company is "in good shape." Comparison of current ratios is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.

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