Quick Guide: The Current Ratio
Calculating financial ratios and metrics can be a time-consuming project.
Our goal at DiscoverCI is to provide the tools and resources you need to spend less time finding and calculating data, and more time analyzing data.
The calculator above is a useful tool in order to calculate the current ratio, but it takes more than just the calculation to use it effectively during your analysis.
The post below quickly outlines the details of the current ratio, including how its calculated, what it measures, an example to assist in your financial ratio analysis, and a 5 step process for analyzing the ratio. With the calculator, a good understanding of the ratio, and your brainpower, you'll have everything you need to effectively and efficiently analyze a company's current ratio.
What is the formula for the current ratio
The ratio is calculated by taking a company’s current assets, and dividing that by the company’s current liabilities. Or in other words:
Current Ratio = Current Assets / Current Liabilities
What does the current ratio measure
This ratio is part of a larger family of financial ratios known as liquidity ratios, which measure a company’s ability to meet its obligations using its short term assets (check out our deep dive into liquidity ratios, which you can use to further understand how these ratios impact your financial analysis).
The current ratio specifically focuses on a company’s current assets relative to its current liabilities, and tells you whether a company’s assets that are expected to be converted to cash within one-year are sufficient to pay amounts due to creditors within one-year.
What is a good current ratio
Analyzing whether a company's ratio is strong depends on various factors, including the nature of the company’s operations, the trend of the company’s ratio over time, and how the company measures up to its peer group and industry competitors.
In most cases, the higher the ratio, the better. A higher ratio indicates a company is well positioned to pay off its upcoming debts.
A company with a ratio that is higher than 1 may be worth looking into further, but generally you would like to see it closer to 1.5 or above. Anything below 1 would indicate there could be trouble up ahead, as the company’s current assets are less than their current liabilities, and the likelihood of that company surviving, much less thriving, starts to dip.
Those are only general benchmarks.
In order to use this ratio to understand how a company is performing, and using that information to confidently make a decision requires further analysis.
The 5 steps for powerful financial ratio analysis
Analyzing financial ratios can be difficult, and knowing where to start and how to complete your analysis prevents some people from ever getting started.
We'll touch on five key steps to simplify your analysis of a company's current ratio below.
If you're interested in learning more about financial ratio analysis, including examples of how to complete and interpret the results of your analysis, we've covered this framework and walked through the below steps in greater detail here.
1. Analyze the Historical Trends of the Company
The first step in your analysis is to see what you can learn from the historical results of the Company. Once you know where a company currently stands, you can use this information to evaluate whether there are positive or negative trends that could impact the future results of the company.
2. Identify the Company’s Industry and Sector
The second step in your analysis is to research the company and identify its industry and sector. A good place to start is a company’s Standard Industrial Classification (“SIC”) Code. You can find this information in a company’s SEC filings and check out a full list of reported sectors here.
For broader industry categories, using an advanced stock screener or other research tools should give you what you need.
3. Understand the Nature of the Company’s Operations
Not all companies within the same industry or SIC classification would be a competitor of the company you are evaluating. A few examples of key characteristics to consider in your analysis are:
- Customer Base
- Life cycle of the Company
Once a company’s industry and key operating characteristics are identified, the next step is building up a list of companies with similar operations to use as a peer group in your analysis.
4. Define the Company’s Industry and Peer Group
The goal of identifying and grouping companies with similar characteristics is to use this list to accurately compare and benchmark one company’s ratio, against another. If you don’t get this part of your analysis right, it can lead to misinterpretations down the road.
There are several ways you can track down the information needed to form a peer group. Various tools and stock screeners on the web should have the information needed to analyze multiple companies. We covered this process in greater detail in our article that walks through how to use DiscoverCI’s stock screener to quickly find and evaluate a company’s peer group.
5. Evaluate How the Company Measures Up
At this point we have the company’s ratio, a good understanding of how the ratio is trending over time, and also a solid list of comparable companies. The next step is reviewing the financial statements and ratios of the company and its peer group to see where the company lands.
An example of the current ratio
Let’s take a look at a quick example:
Apple Inc. (AAPL) reported current assets of $128,645,000 (in thousands, $USD) and current liabilities of $100,814,000 (in thousands, $USD) as of September 30, 2017.
Using the formula we outlined above, the company’s ratio pencils out to:
1.28 = $128,645,000 / $100,814,000
Evaluating a company’s current ratio will give you a good idea of whether a company is well positioned to pay off their short term liabilities using their short term assets. Strong companies manage their cash flows and net working capital effectively, so they have enough cash generating assets to pay vendors, creditors, and other obligations as they become due.
You are now set with the tools and understanding you need to calculate and analyze the current ratio, but don’t stop there! Be sure to check out the best collection of financial ratio calculators on the web, as well as our blog to help in your analysis here and subscribe to our email list to become a member of the DiscoverCI Community.