Current Ratio
Key Takeaways
- 01.Calculated as Current Assets / Current Liabilities.
- 02.Measures a company's short-term liquidity and solvency.
- 03.A ratio < 1.0 indicates that a company may struggle to pay its immediate obligations.
- 04.An excessively high ratio (> 4.0) can indicate inefficient capital management, such as holding too much cash.
Why it matters
Profitability does not guarantee survival; if a company runs out of cash to pay its suppliers or short-term loans, it can go bankrupt despite being profitable on paper. The Current Ratio is a key measure of safety.
When it matters
It is critical when analyzing companies with tight cash flows or during cash-crunches, where liquidity is vital.
Comparing liquid current assets vs short-term obligations on a balance sheet.
Adjust the levels of inventory and cash to see how they impact the Current and Quick ratios.
Common Mistakes
Assuming all current assets are equally liquid
Current assets include inventory and accounts receivable. If inventory is obsolete and cannot be sold, it will inflate the Current Ratio without providing actual liquidity. Use the 'Quick Ratio' (excluding inventory) as a double check.
📖 Real-World Example: A classic liquidity squeeze
A retailer's current ratio was 1.8, which seemed healthy. However, 80% of its current assets consisted of unsold inventory. When a sudden lockdown occurred and stores closed, it could not convert inventory to cash, and it default on its short-term debt due to lack of immediate liquidity.