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Comments about the Current Ratio
The Current Ratio is calculated using this formula: Current Assets divided by Current Liabilities. The Current Ratio provides insights about the liquidity of a business by comparing current assets to current liabilities. In other words, it is a measure of the company's ability to meet its short-term debt obligations. Liquidity relates to a customer’s ability to pay debts as they come due. From this, we can infer that the higher the current ratio, the lower the risk of payment delinquency or payment default.
As rule of thumb, current ratios in many industries of 2 to 1 are considered the norm. More than $2 in current assets for every $1 in current liabilities is considered a positive as it relates to the company or customer's liquidity. A current ratio of less than 2 to 1 is normally less than ideal. The further below a current ratio of 2 to 1, the more concern a trade creditor should have about the company's liquidity - meaning its ability to retire debts as they come due.
Current Liabilities are debts due or maturing within one year from the date of the balance sheet. Current Assets normally include cash, short-term marketable securities, accounts receivable, and inventory.
It is easy to understand why many creditors look at changes in the current ratio as an important tool for evaluating credit risk. Consider these ideas:
- The actual timing of cash inflows and outflows determines whether or not a customer is capable of paying invoices as they came due.
- It was possible for a company to have a low current ratio and have no trouble paying its bills. For example, a customer could have a low current ratio, but a large working capital line of credit that could be used to pay creditors invoices. Or, a company that has a continuous and reliable inflow of cash [such as might be the case with a supermarket] may be capable of meeting current liabilities easily despite a low current ratio.
- Irrespective of how high how low a current ratio may be, it is important to see how the customer is paying other trade creditors.
- Just because a customer can pay invoices on time does not mean the customer will pay invoices when they come due.
© 2011 by Michael C. Dennis. All Rights Reserved.