Current ratio

What it means

The current ratio is current assets divided by current liabilities. It shows how many times a company could cover debts due within a year if it turned all inventory, receivables and short-term financial assets into cash.

In practice a value of roughly 1.5 to 2.5 is considered healthy. Below 1 means current liabilities exceed current assets and the company is funding part of them from long-term sources or is under strain.

It is the loosest of the three liquidity measures. The quick ratio, which excludes inventory, and the cash ratio, which counts only cash, are stricter.

How it works in practice

Banks and suppliers look at the current ratio when assessing creditworthiness. It is often a loan covenant, and a drop below the agreed threshold can mean a breach.

The ratio is calculated from the balance sheet at the reporting date. It is worth tracking during the year too, because the year-end figure can be distorted, for example by repaying a loan just before closing.

The current ratio can be improved by refinancing short-term loans as long-term, collecting receivables faster or adding equity. It is closely linked to working capital management.

What to watch out for

A high current ratio is not necessarily good news. If it consists of slow-moving stock or uncollectable receivables, the company may struggle to pay its bills even though the number looks excellent.

Comparisons should be made within the sector. A retailer with fast stock turnover operates safely with lower liquidity; a manufacturer with a long cycle needs more.