Current Ratio

How is it calculated?

Current Ratio = Current Assets / Current Liabilities

Goal of the Ratio

The goal of this ratio is to show the ability of a borrower to meet short term payment obligations with existing short term assets currently on hand.

When is it used?

This ratio is primarily used for operating entities.  This ratio is less relevant for entities such as real estate holding companies.

Rules of Thumb

Higher is better - Please note all ratios should be viewed in relation to industry norms to determine overall adequacy.

Pitfalls of this Ratio

Not all current assets are the same.  Current assets include all assets that will be typically converted into cash in the coming 12 months, but some assets are farther away from becoming cash than others.  Assets such as inventory will take longer to convert into cash than assets such as accounts receivable; so the ratio should be viewed in relation to the market up of the current assets and current liabilities.  

When comparing to peer averages, be sure to factor in items such as Current Portion of Long Term Debt (CPLTD) or Current Maturities of Long Term Debt (CMLTD), because the peer averages typically factor these items in, and if your borrower does not include them (which typically an internally prepared balance sheet or tax return do not) you potentially will overstate a borrower’s liquidity position relative to the industry norm.

What changes in the ratio could mean:

Some example reasons why Current Ratio can change:

1. Profitable Net Income
2. Unprofitable Net Income
3. Ownership Contributions
4. Ownership Distributions
5. Sale of Fixed Assets
6. Purchase of Fixed Assets
7. Additional Principal Reduction on LT Debt
8. WC Injection through new borrowings 

Other Relevant Terms

• Capital
• Balance Sheet
• Working Capital
• Liquidity
• Return to Terminology Library