Current Ratio: Calculations, Examples, and Meaning

The Current Ratio, calculated as Current Assets / Current Liabilities, tells you if a company’s short-term liquidity can cover its short-term liabilities or owed payments; if it cannot, the company can run into trouble in a recession, downturn, or other stressed scenario.

The Current Ratio is an example Liquidity Ratio; like the others, it’s a measure of the company’s operational and credit risk.

However, it is broader than the Cash Ratio or Quick Ratio and, therefore, less stringent when it comes to “stress testing” the company.

They key difference is that unlike the others, the Current Ratio also includes less-liquid assets, such as Inventory, that may be more difficult to convert into Cash on short notice.

Files & Resources:

Liquidity Ratios – Slides (PDF)

Liquidity Ratios – Extracts from Illinois Tool Works Filings (PDF)

Illinois Tool Works – Liquidity Ratio Analysis (XL)

Video Table of Contents:

1:39: Part 1: The Top 3 “OG” Liquidity Ratios
4:00: Part 2: Unofficial Liquidity Ratios
8:25: Part 3: Liquidity Ratios in Real Life for Illinois Tool Works
10:44: Recap and Summary

What is the Current Ratio?

Current Ratio Definition: The Current Ratio equals a company’s Current Assets divided by its Current Liabilities. It indicates whether a company can adequately meet its short-term funding obligations using its liquid assets. A ratio above 1.0x is generally considered favorable, and in most scenarios, the higher the ratio, the better the company’s short-term financial standing (within reason).

A low figure might indicate potential liquidity issues, while a very high number could mean that the company is too conservative with its Cash and other assets.

While this might help the company in the short term, in the long term, it might lead to misallocation of capital and under-investment in growth, which the company’s investors would not appreciate.

You can see an example of the calculation for Illinois Tool Works [ITW] below (see the Excel file and filing PDF above):

The Current Ratio here is 1.41x, which means that ITW has $1.41 of current assets for each $1.00 in current liabilities.

Most people would say this is a “good sign” for the company, but you also need to consider the trends and changes over time.

If the company’s liquidity has fallen sharply in recent years, this 1.41x figure could be a cause for concern.

Limits of the Current Ratio Formula

While the Current Ratio is a useful metric, it also has some limitations:

1) Nature of Assets: It doesn’t distinguish between the company’s Minimum vs. Excess Cash, nor does it break out the Restricted Cash that can’t be used to pay for short-term obligations. It lumps all current assets together, potentially giving an inflated sense of liquidity.

2) Illiquid Short-Term Investments: Some current assets may not be easily convertible to Cash within a few months – even if the company labels them “short-term” – which could pose challenges if the company needs liquidity urgently.

3) Deferred Revenue Balances: High Deferred Revenue balances could skew the numbers for SaaS or subscription-based companies. While these are considered current liabilities, they represent Cash the company has collected upfront for products/services it has yet to deliver, which is almost always a positive since companies want to collect Cash as soon as possible from customers.

So, while the Current Ratio is valuable, you should always dig deeper and assess the composition of the current assets and liabilities before reaching any conclusions.

The Current Ratio in Financial Models and Valuations

The Current Ratio is usually an output metric rather than a driver in financial modeling and valuations. Here’s how it’s typically used:

1) Performance Gauge: Analysts often look at this ratio to gauge a company’s operational efficiency and ability to manage its short-term obligations. They may view companies with higher ratios as more efficient and, therefore, more deserving of higher valuations.

2) Liquidity Assessment: A sound Current Ratio suggests that the company has sufficient liquidity, which can be attractive to potential investors or creditors, as it means the company is unlikely to run into operational troubles due to a lack of funding.

3) Credit Risk Indicator: Lenders and other financial institutions might use this ratio to evaluate a company’s credit risk. A lower ratio might indicate higher risk, potentially leading to unfavorable lending terms.

However, remember that a “good” Current Ratio varies across industries.

For example, retail companies might maintain higher numbers because they need significant Inventory, while tech firms might operate comfortably with lower numbers because Inventory is far less important for them, and current liabilities such as Deferred Revenue tend to be much higher.

Current Ratio Conclusions

Like all Liquidity Ratios, the Current Ratio has it uses, but you should use it in a broader context of all the operational and credit stats.

Never look at a single number and “decide” how risky a company is; you always want to look at a range of different metrics and see how they vary over time.