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The current ratio is a metric used by accountants and finance professionals to understand a company’s financial health at any given moment. This ratio works by comparing a company’s current assets (assets that are easily converted to cash) to current liabilities (money owed to lenders and clients).
In this guide, we’ll cover:
- Current Ratio Definition
- Current Ratio Formula
- What Is a Good Current Ratio?
- Current Ratio vs. Quick Ratio
- Showing Current Ratio Skills on a Resume
- Related Skills for Accounting Careers
Current Ratio Definition
The current ratio is also referred to as the working capital ratio. This ratio compares a company’s current assets to its current liabilities, testing whether it sustainably balances assets, financing, and liabilities. Typically, the current ratio is used as a general metric of financial health since it shows a company’s ability to pay off short-term debts.
Within the current ratio, the assets and liabilities considered often have a timeframe. For example, liabilities in this ratio are usually due within one year. On the other hand, current assets in this formula are resources the company will use up or liquefy (converted to cash) within one year.
Who Uses this Ratio?
Business owners and the financial team within a company may use the current ratio to get an idea of their business’s financial well-being. Accountants also often use this ratio since accounting deals closely with reporting assets and liabilities on financial statements.
Outside of a company, investors and lenders may consider a company’s current ratio when deciding if they want to work with the company. For example, this ratio is helpful for lenders because it shows whether the company can pay off its current debts without adding more loan payments to the pile.
Current Ratio Formula
The formula to calculate the current ratio is:
Current Ratio = Current Assets / Current Liabilities
Components of the Formula
Current Assets
Current assets are a company’s resources that could be liquified within one year. Some common types of current assets include:
- Cash and cash equivalents: Paper cash, coin, or currency, as well as the balance of checking and savings accounts
- Marketable securities: Financial instruments available for sale or purchase on public exchanges, such as stocks and bonds
- Accounts receivable: Money owed to a company by clients and customers
- Inventory: Goods a company sells and the materials used to produce goods
- Other current assets: Assets too rare or insignificant to warrant a full category on their own, including selling a piece of equipment or real estate (Prepaid expenses, like prepaid rent or taxes, may also fall into the “other current assets” category, depending on the company.)
It is important to note that a similar ratio, the quick ratio, also compares a company’s liquid assets to current liabilities. However, the quick ratio excludes prepaid expenses and inventory from the assets category because these can’t be liquified as easily as cash or stocks.
Current Liabilities
Current liabilities are debts the company must repay within the following year. Some categories of liabilities include:
- Accounts payable: Money a company owes to clients, creditors, customers, and suppliers
- Term debt: A loan or other form of financing with fixed interest rates
- Deferred revenue: Money that the company receives from customers before delivering goods or services — sometimes referred to as unearned income
- Other current liabilities: Inconsequential or uncommon fees that are too minor to have a separate category on the balance sheet — includes miscellaneous fees, accrued property taxes, or unpaid costs associated with franchise operations
>>MORE: Find out if a career in accounting is right for you.
Example of How to Calculate the Current Ratio
A balance sheet lists all the details needed to calculate the current ratio. The balance sheet is typically part of any large fiscal report, such as a quarterly or annual earnings report. Using Apple’s earnings report for the fiscal year 2022, we can find the following details on the balance sheet:
Apple’s Reported Current Assets
| Cash and cash equivalents | $23,646 million |
| Marketable securities | $24,658 million |
| Accounts receivable | $28,184 million |
| Inventories | $4,946 million |
| Other current assets | $53,971 million |
| Total current assets | $135,405 million |
Apple’s Reported Current Liabilities
| Accounts payable | $64,115 million |
| Term debt | $11,128 million |
| Deferred revenue | $7,912 million |
| Other current liabilities | $70,827 million |
| Total current liabilities | $153,982 million |
With this information, we have the following formula:
Current Ratio = $135,405m (current assets) / $153,982m (current liabilities)
So, Apple’s current ratio for 2022 was: 0.88
Current ratios can be written in decimals or as X:X type ratios. So, for Apple, we could also say it has a current ratio of 88:100 (or a simplified ratio of 22:25).
However, showing current ratios as an actual ratio rather than a decimal may be more confusing and doesn’t always convey the necessary information as effectively as a decimal. For example, while 117:100 would be a generally good current ratio, 1.17 may be easier to understand.
>>MORE: Learn in-demand accounting skills with the Jefferies Fixed Income and Equities Virtual Experience Program.
What Is a Good Current Ratio?
The current ratio describes the relationship between a company’s assets and liabilities. So, a higher ratio means the company has more assets than liabilities. For example, a current ratio of 4 means the company could technically pay off its current liabilities four times over. However, what makes a good current ratio depends on the industry. Generally speaking, having a ratio between 1 and 3 is ideal, but certain industries or business models may operate perfectly fine with lower ratios.
There are many reasons for a company to have a lower current ratio. For example, the inventory listed on a balance sheet shows how much the company initially paid for that inventory. Since companies usually sell inventory for more than it costs to acquire, that can impact the overall ratio. Additionally, a company may have a low back stock of inventory due to an efficient supply chain and loyal customer base. In that case, the current inventory would show a low value, potentially offsetting the ratio.
However, high ratios aren’t always great, either. A high ratio can indicate that the company is not effectively utilizing its assets. For example, companies could invest that money or use it for research and development, promoting longer-term growth, rather than holding a large amount of liquid assets.
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Current Ratio vs. Quick Ratio
The current ratio and quick ratios measure a company’s financial health by comparing liquid assets to current or pressing liabilities. However, there are a few key differences between these ratios.
First, the quick ratio excludes inventory and prepaid expenses from liquid assets, with the rationale being that inventory and prepaid expenses are not that liquid. Prepaid expenses can’t be accessed immediately to cover debts, and inventory takes time to sell.
Another difference is in the evaluation of each ratio. The current ratio can be useful for judging companies with massive inventory back stock because that will boost their scores. On the other hand, the quick ratio will show much lower results for companies that rely heavily on inventory since that isn’t included in the calculation. The quick ratio is often more conservative overall.
Ultimately, there is no one ratio to determine a company’s health. It’s ideal to use several metrics, such as the quick and current ratios, profit margins, and historical trends, to get a clear picture of a company’s status.
>>LEARN MORE: What Is the Quick Ratio?
Showing Current Ratio Skills on a Resume
Prior work or internship experience evaluating a company’s financial health will generally imply a working knowledge of the current ratio. However, you can include some details in the description of that experience. For example, you could say something like:
- “Analyzed and quantified the business’s financial health using key metrics, including the quick ratio, current ratio, and profit margins.”
You can also use the skills section of your resume to describe specific calculations you know, such as the current ratio, or include it as part of a wider skillset. For example, in your skills section, you could include:
- “In-depth understanding of vital business performance metrics, including revenue, profit margins, and current ratios.”
However, if you learned this skill through other means, such as coursework or on your own, your cover letter is a great place to go into more detail. For example, you could describe a project you did at school that involved evaluating a company’s financial health or an instance where you helped a friend’s small business work out its finances.
>>MORE: See the top 5 skills for resumes in 2022.
It is crucial for accountants and many finance professionals to know how to evaluate a company’s financial health accurately. Other skills necessary in an accounting or finance career include:
- Attention to detail
- Understanding finance concepts, like assets and liabilities
- Working knowledge of the accounting equation
- Familiarity with other formulas, like the price-to-earnings ratio
Learn the skills you need for a career in finance with Forage’s free accounting virtual experience programs.
Image credit: alebloshka / Depositphotos.com
Written by
McKayla Girardin→
Writer
Read more from McKayla Girardin
McKayla Girardin is a NYC-based writer with Forage. She is experienced at transforming complex concepts into easily digestible articles to help anyone better understand the world we live in.
