Current Ratio Explained With Formula and Examples (2024)

Two things should be apparent in the trend of Horn & Co. vs. Claws Inc. First, the trend for Claws is negative, which means further investigation is prudent. Perhaps it is taking on too much debt or its cash balance is being depleted—either of which could be a solvency issue if it worsens. The trend for Horn & Co. is positive, which could indicate better collections, faster inventory turnover, or that the company has been able to pay down debt.

The second factor is that Claws’ current ratio has been more volatile, jumping from 1.35 to 1.05 in a single year, which could indicate increased operational risk and a likely drag on the company’s value.

Example Using the Current Ratio

In its Q4 2022 fiscal results, Apple Inc. reported total current assets of $135.4 billion, slightly higher than its total current assets at the end of the last fiscal year of $134.8 billion. However, the company's liability composition significantly changed from 2021 to 2022. At the 2022, the company reported $154.0 billion of current liabilities, almost $29 billion greater than current liabilities from the prior period.

For 2021, Apple had more current assets than current liabilities. Its current ratio was ($134.836b / $125.481b) 1.075. This means that if all current liabilities of Apple were immediately due, the company could pay all of its bills without leveraging long-term assets.

At the end of 2022, it was a slightly different story. Apple's current ratio was ($135.405b / $153.982b) 0.88. This means that Apple technically did not have enough current assets on hand to pay all of its short-term bills. Analysts may not be concerned due to Apple's ability to churn through production, sell inventory, or secure short-term financing (with its $217 billion of non-current assets pledged as collateral, for instance).

Current Ratio vs. Other Liquidity Ratios

Other similar liquidity ratios can supplement a current ratio analysis. In each case, the differences in these measures can help an investor understand the current status of the company’s assets and liabilities from different angles, as well as how those accounts are changing over time.

The commonly used acid-test ratio, or quick ratio, compares a company’s easily liquidated assets (including cash, accounts receivable, and short-term investments, excluding inventory and prepaid expenses) to its current liabilities. The cash asset ratio, or cash ratio, also is similar to the current ratio, but it only compares a company’s marketable securities and cash to its current liabilities.

Companies may use days sales outstanding to better understand how long it takes for a company to collect payments after credit sales have been made. While the current ratio looks at the liquidity of the company overall, the days sales outstanding metric calculates liquidity specifically to how well a company collects outstanding accounts receivables.

Finally, the operating cash flow ratio compares a company’s active cash flow from operating activities (CFO) to its current liabilities. This allows a company to better gauge funding capabilities by omitting implications created by accounting entries.

Limitations of Using the Current Ratio

One limitation of the current ratio emerges when using it to compare different companies with one another. Businesses differ substantially among industries; comparing the current ratios of companies across different industries may not lead to productive insight.

For example, in one industry, it may be more typical to extend credit to clients for 90 days or longer, while in another industry, short-term collections are more critical. Ironically, the industry that extends more credit actually may have a superficially stronger current ratio because its current assets would be higher. It is usually more useful to compare companies within the same industry.

Another drawback of using the current ratio, briefly mentioned above, involves its lack of specificity. Unlike many other liquidity ratios, it incorporates all of a company’s current assets, even those that cannot be easily liquidated. For example, imagine two companies that both have a current ratio of 0.80 at the end of the last quarter. On the surface, this may look equivalent, but the quality and liquidity of those assets may be very different, as shown in the following breakdown:

In this example, Company A has much more inventory than Company B, which will be harder to turn into cash in the short term. Perhaps this inventory is overstocked or unwanted, which eventually may reduce its value on the balance sheet. Company B has more cash, which is the most liquid asset, and more accounts receivable, which could be collected more quickly than liquidating inventory. Although the total value of current assets matches, Company B is in a more liquid, solvent position.

The current liabilities of Company A and Company B are also very different. Company A has more accounts payable, while Company B has a greater amount in short-term notes payable. This would be worth more investigation because it is likely that the accounts payable will have to be paid before the entire balance of the notes-payable account. Company A also has fewer wages payable, which is the liability most likely to be paid in the short term.

In this example, although both companies seem similar, Company B is likely in a more liquid and solvent position. An investor can dig deeper into the details of a current ratio comparison by evaluating other liquidity ratios that are more narrowly focused than the current ratio.

The Bottom Line

The current ratio is a useful liquidity measurement used to track how well a company may be able to meet its short-term debt obligations. It compares the ratio of current assets to current liabilities, and measurements less than 1.0 indicate a company's potential inability to use current resources to fund short-term obligations.