Current Ratio Formula: How to Calculate Current Ratio and Why It Is Important for a Business?

“With just a simple formula, you’re able to analyze a company’s financial health.”

Yes, you read it right! The current ratio formula helps business owners and individuals to depict an organization’s financial conditions. It calculates all current assets and current liabilities to analyze short-term liquidity and the ability to cover debts.

So, if you also want to monitor your business’s overall financial state, you are at the right place! Here, I’ve compiled detailed information on the current ratio equation, how to calculate the current ratio, and the advantages and disadvantages.

Let’s dive in to explore more! 

What is the Current Ratio & the Current Ratio Formula? 

The current ratio is one of the most widely used financial ratios that businesses use to evaluate and determine their short-term liabilities in relation to their short-term assets. In simple terms, the current ratio formula summarizes how effectively a business meets its short-term obligations. 

If you still didn’t get where it is used, the working capital ratio, another term for the current ratio formula, might help. It is the same working capital ratio that is calculated when the financial health of a company is analyzed. 

Current Ratio = Current Assets / Current Liabilities

Different Elements of the Current Ratio Formula

Let’s see what the different components of the current ratio formula are: 

Current Asset 

This term refers to business assets that are easily convertible into cash, sellable, or usable within one year or the accounting period. It is essential to understand short-term liquidity, which enables the meeting of immediate obligations.

• Examples: Cash and cash equivalents, accounts receivable, inventory, marketable securities, and prepaid expenses. 

Current Liability 

It is a short-term financial obligation that a company expects to pay within one year or accounting period. Current liability is reported on the company’s balance sheet and cash flow statement.

• Examples: Accounts payable, wages payable, short-term debt, deferred revenue, and current portion of long-term debt.

What’s the Use of the Current Ratio Formula?

The main purpose of the current ratio formula is to analyze a company’s financial state. If a current ratio is above 1, it indicates that an organization can cover its liabilities. On the other hand, a current ratio below 1 can be alarming for a business owner. That’s why it is essential to use the current ratio formula to depict your financial health.

Let’s take a deep dive into the practical uses of the current ratio formula:

1. Assessing Short-Term Liquidity

You can quickly get a snapshot of the company’s ability to pay its short-term debts by using the current ratio equation. It helps evaluate an organization’s financial health and uncover how the financial officer manages the working capital.

2. Reviewing Creditworthiness

Lenders or investors frequently use the current ratio equation or formula to assess a company’s credit risk. A higher current ratio suggests a lower risk, making the company trustworthy for loans and investments. 

3. Industry Comparison

Sometimes, you can use the current ratio to compare your distinct departments to the average. It helps you to figure out areas where your company might be underperforming and encourages you to enhance the work performance.

4. Internal Management

The best part of utilizing the current ratio formula is to monitor your business’s financial parameters. It assists you in making informed decisions and managing working capital efficiently. Besides this, it helps in operating inventory, accounts receivable, accounts payable, and other business operations.

5. Pricing Strategy

In some cases, the current ratio can determine a company’s pricing strategy. A healthy ratio empowers a company to be more flexible and strategic in pricing decisions. It enhances the organization’s ability to offer more competitive pricing and profitability.

How to Calculate Current Ratio with the Current Ratio Equation? 

Before using the current ratio in your business, you have to understand how to calculate it. Basically, you have to gather all financial information, calculate current assets and liabilities, and then apply the formula.

Here, I break down the current ratio calculation formula step-by-step in great detail; just follow it.

1. Collect All Financial Information

Firstly, you should gather reports of your company’s balance sheet. This financial statement has a detailed record of assets, liabilities, and equity. So, you have to identify current assets and liabilities from the balance sheet.

2. Calculate Current Assets

Secondly, add all the values of current assets after identifying them from the balance sheet. This includes cash, marketable securities, accounts receivable, and prepaid expenses.

3. Calculate Current Liabilities

After adding current assets, it’s time to sum up current liabilities from the balance sheet. Liabilities such as taxes payable, short-term debt, accrued expenses, and accounts payable should be calculated.

4. Use Current Ratio Formula

Now, you should divide current assets by current liabilities using the formula to calculate the current ratio.

Current Ratio Formula = Current Assets/Current Liabilities

See how easy it is! You can analyze your company’s financial health just by calculating current assets and current liabilities.

Examples of the Current Ratio Formula 

Let’s understand how to calculate the current ratio formula with some real-time examples. This way, you can easily evaluate your company’s ability to pay debts or short-term obligations.

Example 1: A “Doodle Pvt. Ltd.” company holds cash of $20 million, short-term debt of $12 million, inventory of $25 million, marketable securities of $10 million, and accounts payable of $5 million. Now, calculate the current ratio of this organization.

First, calculate current assets and current liabilities.

Current Assets = $20 million (Cash) + $25 million (inventory) + $10 million                    (marketable securities)

Total = $55 million

Current Liabilities = $12 million (short-term debt) + $5 million (accounts payable)

Total = $17 million

Now, calculate the current ratio:

Current Ratio Formula = Current Assets/Current Liabilities

                                            $55 million/$17 million

                                            3.23     

The current ratio is higher than 1, which indicates that “Doodle Pvt. Ltd.” is capable of meeting its short-term obligations effectively. On the whole, the firm’s current assets are greater than current liabilities, symbolizing a healthy financial status.

Example 2: A “Wishlist” organization wants to attract investors to lock in the profitable deal. That’s why the finance officer attempts to calculate the current ratio of the company. Help him evaluate the current assets and liabilities of a firm. It includes:

• Accounts payable = $19 million
• Accounts receivable = $5 million
• Short-term debt = $17 million
• Marketable Securities = $10 million
• Inventory = $2 million
• Taxes payable = $6 million

Let’s calculate current assets and current liabilities.

Current Assets = $5 million (accounts receivable) + $10 million (marketable securities) + $2 million (inventory)

Total = $17 million

Current Liabilities = $19 million (accounts payable) + $17 million (short-term debt) + $6 million (taxes payable)

Total = $42 million

Now, utilize the current ratio formula to evaluate.

Current Ratio Formula = Current Assets/Current Liabilities

                                            $17 million/$42 million

                                            0.4

The ratio “0.4” suggests that the company’s short-term assets are not sufficient to cover its short-term liabilities. Hence, the firm might not attract investors due to drastically unfavorable financial conditions.

What is a Good Current Ratio? 

A good current ratio generally falls between 1 and 3.0, but this range may vary across different industries. This ideal range indicates that the particular company has enough assets to cover its short-term obligations. It highlights that an organization is utilizing its assets to cover its debts more effectively.

However, a ratio below 1.0 suggests an alarming situation for the firm. It means that the company would be at risk or have a riskier investment. But, in general, different applications and factors also influence the financial state.

Example 1: An organization undertaking a large project and purchasing a building, which requires significant cash outlays. It will potentially lower its current ratio, even if the company is financially healthy.

Example 2: A well-run company that generates cash quickly can safely operate with a lower current ratio because it can pay suppliers before its own payment obligations are due.

Quick Ratio vs Current Ratio: How Do They Differ? 

The quick ratio and current ratio are both liquidity ratios and significantly measure a company’s financial health. But the quick ratio is a traditional setup that includes only quick assets, and the current ratio calculates all current assets.

Yet, you find it difficult to understand how they differ from each other. Just look at the breakdown table below.

Feature	Quick Ratio	Current Ratio
Purpose	Measure the company’s ability to cover its debts using only liquid assets.	Calculate the company’s financial health using all current assets, including inventory and prepaid expenses.
Formula	(Cash + Marketable Securities + Accounts Receivable)/Current Liabilities	Current Assets/Current Liabilities
Assets Considered	High liquid assets like cash, marketable securities, and accounts receivable. It doesn’t calculate inventory and prepaid expenses.	All current assets, such as cash, marketable securities, accounts receivable, inventory, and prepaid expenses.
Efficiency	Provide real-time insights into immediate financial health and ability to meet obligations.	Offer a snapshot of short-term solvency over a long period, usually one year.
Time Sensitivity	Focus on showcasing immediate liquidity and the ability to cover sudden financial expenses.	Reflects liquidity at a specific time period, including all current assets and liabilities within a year.

Advantages and Disadvantages of Using Current Ratio 

While the current ratio offers a broad picture of a company’s ability to meet its obligations, it also comes with some drawbacks. It does not evaluate long-term liability and represents an incomplete picture of liquidity. That’s why it is essential to be aware of the advantages and disadvantages to make informed decisions.

Advantages of Using the Current Ratio

Let’s take a look at how using the current ratio formula can be beneficial for the business.

• Comparative Analysis: It facilitates comparison between two companies in the same industry to uncover capabilities, weaknesses, and potential areas of improvement.

• Broad View of Liquidity: By assessing all current assets and liabilities of an organization, you can easily get a detailed picture of the company’s short-term liquidity.

• Trend Analysis: An increasing current ratio suggests improved liquidity, while a decreasing ratio signals potential issues. So, you have to consider improving your potential areas.

Disadvantages of Using Current Ratio

Since the current ratio formula is quite helpful to analyze a business’s financial health, it also has some sort of drawback. So, take a look at the subsequent section for detailed guidance.

• Incomplete Liquidity Analysis: The current ratio formula includes all assets that may not easily convert into cash, leading to an incomplete picture of liquidity.

• Ignoring Long-Term Liabilities: It only calculates current assets and current liabilities and ignores long-term obligations. This illustrates that a company might appear financially stable in a short period but could face difficulties in covering long-term liabilities.

• Need for Additional Ratios: It is apparently unfair to solely rely on the current ratio equation because it can mislead about the financial state. So, you must evaluate the quick ratio and cash ratio for more detailed insights.

Wrapping Up 

The current ratio formula is used to assess a company’s financial health. This represents an organization’s ability to meet its short-term obligations. A current ratio above 1 suggests a company’s healthy financial status, while a ratio below 1 is a signal of financial risks.

However, if you find it difficult to calculate the current ratio equation, you can hire a business strategy financial consultant or professionals for personalized guidance.