The current ratio measures how well a company is able to pay off its short-term debt. In order to understand what the current ratio means for a given company, we must first understand how it’s calculated.
To get the current ratio you divide the current assets by the current liabilities.
- Current assets are the company’s assets that are expected to be sold or used over the next year. Current assets include things like cash, cash equivalents, and inventory.
- Current liabilities are the company’s short-term debt, due within a year.
Let’s use Microsoft as an example. Below are the current assets and current liabilities from the most recently released statement.
As you can see, the current assets were (in millions) $173,973, and the current liabilities $67,486. So, if we divide the current assets by the current liabilities, we will get a current ratio of 2.57.
This means that for every $1 Microsoft has in current liabilities, it also has $2.57 in current assets. A current ratio of 2.57 would probably be considered good. It might even be a little too high. Yes, you heard me right. The current ratio can be too high, something we’ll talk more about in a minute.
Now, imagine a company with $15 million in current assets and $17 million in current liabilities. Current assets ($15m) divided by current liabilities ($17m) results in a current ratio of 0.88.
This means that for every $1 the company has in current liabilities, it only has $0.88 in current assets to cover it.
What is a Good Current Ratio?
A current ratio of 1 means that the company is just able to cover its current liabilities with its current assets.
Anything below that means that the company can’t cover its short-term debt and might need to raise money either through more debt or the issuing of additional shares.
Many investors prefer a higher current ratio than 1 to be comfortable, though. Warren Buffett, for example, likes a current ratio above 1.5.
Generally speaking, 1.5 to 2 is considered a good current ratio but it also depends on the industry in which the company operates.
It’s not unusual for a retail company like Walmart to have a current ratio of around 0.8. That’s why you should always compare ratios to companies operating in the same industry.
What Does a High Current Ratio Indicate?
Firstly, a current ratio of above 2 would probably be considered high. A high current ratio means that the company is well equipped to pay off its short-term debt with its liquid assets.
An important thing to note, though, is that a high current ratio is only attractive up to a certain point, after that, it might be a sign that the company is using its assets ineffectively.
For example, a high current ratio might mean that the company has a pile of cash lying around, and cash is not always king.
The money could have been reinvested to make the company even more money or used to pay off debt. Or it could have been distributed to the shareholders.
A high current ratio can also be the result of a large inventory. A large inventory could mean that the company is unable to sell its products, which could mean that the inventory isn’t worth as much as stated on the balance sheet.
In other words, you can’t rely on the current ratio alone. Every company is different and you need to look at what the current assets and liabilities are made up of.
What Does a Low Current Ratio Indicate?
A low current ratio (below 1) can indicate that the company is unable to cover its short-term debt with its liquid assets and might need to raise more capital.
A low current ratio isn’t necessarily a bad thing, though. It could be the result of an efficiently run company.
For example, an efficient retail company with a high inventory turnover might not carry a large inventory on its balance sheet and might therefore have a low current ratio.
In this case, the current ratio isn’t a good indicator of the company’s financial health. You would probably be better off looking at the cash flow statement to see if the company is bringing in enough cash.
For this kind of company, the current ratio’s use is limited but could be used to compare to either the company’s historical ratio or to that of similar companies.
Average Current Ratio by Industry
Below are the current ratio averages for some of the largest industries. (Source)
|Industry||Average Current Ratio|
|Oil and Gas Extraction||1.02|
|Mining of Nonmetallic Minerals (Fuels Excluded)||1.59|
|Building Construction General Contractors||2.09|
|Food and Kindred Products||1.52|
|Apparel And Other Finished Products Made From Fabrics And Similar Materials||1.45|
|Paper and Allied Products||1.80|
|Printing, Publishing, and Allied Industries||1.20|
|Chemicals and Allied Products||3.47|
|Petroleum Refining and Related Industries||1.46|
|Rubber and Miscellaneous Plastic Products||1.92|
|Stone, Clay, Glass, and Concrete Products||1.99|
|Primary Metal Industries||2.18|
|Fabricated Metal Products, Except Machinery and Transportation Equipment||2.27|
|Industrial and Commercial Machinery and Computer Equipment||1.97|
|Electronic And Other Electrical Equipment and Components, Except Computer Equipment||2.36|
|Measuring, Analyzing, and Controlling Instruments; Photographic, Medical and Optical Goods; Watches and Clocks||2.53|
|Miscellaneous Manufacturing Industries||1.92|
|Electric, Gas, and Sanitary Services||0.80|
|Wholesale Trade-durable Goods||1.88|
|Wholesale Trade-non-durable Goods||1.39|
|Building Materials, Hardware, Garden Supply, and Mobile Home Dealers||1.58|
|General Merchandise Stores||1.25|
|Automotive Dealers And Gasoline Service Stations||1.13|
|Apparel And Accessory Stores||1.39|
|Home Furniture, Furnishings, and Equipment Stores||1.41|
|Eating and Drinking Places||0.58|
|Non-depository Credit Institutions||0.77|
|Security and Commodity Brokers, Dealers, Exchanges, and Services||3.07|
|Insurance Agents, Brokers, and Service||1.29|
|Holding and Other Investment Offices||0.75|
|Hotels, Rooming Houses, Camps, and Other Lodging Places||1.10|
|Automotive Repair, Services, and Parking||0.76|
|Amusement and Recreation Services||0.87|
|Engineering, Accounting, Research, Management, and Related Services||1.31|
The current ratio shows you how well the company is able to pay off its short-term debt using its liquid assets. You get it by dividing the current assets by the current liabilities.
A current ratio of 1 means that the company can cover its current liabilities with its current assets. A ratio of 2.5 means that the company has $2.5 of current assets for every $1 of current liabilities.
If the current ratio is too high, it might mean that the company is inefficiently using its assets. And while a low ratio can mean that the company is unable to cover its short-term debt, it could also mean that the company is using its resources efficiently.
Like with most ratios, what might be a high ratio for one industry, could be considered low for another. Therefore it’s important to compare current ratios between companies operating in the same industry.