What is current ratio?
Current ratio is a financial metric that measures a company's ability to pay its short-term liabilities with its current assets. This metric is an important indicator of a company's financial health and its ability to meet its short-term obligations.
How to calculate current ratio?
To calculate the current ratio, divide a company’s ‘total current assets’ by its ‘total current liabilities’. Current assets are assets that can be easily converted into cash within one year or less, like – cash and cash equivalents, accounts receivable, short-term investments, inventory, etc.
Current liabilities are a company's short-term financial obligations that are due within one year or less, like – accounts payable, short-term debt, taxes, etc.
Formula for calculating current ratio
Real-life example of current ratio
Let’s say you run an eCommerce business. If your current assets are worth $200,000 and current liabilities worth $100,000. Then, your current ratio will be: 200,000/100,000 = 2:1
This indicates that your company has 2 times more current assets than your current liabilities, which is a good sign.
What’s considered a good current ratio? (benchmark)
A company should have a current ratio of at least 1.0. However, a good current ratio is considered to be between 1.5 - 2 or higher. Different industries and business models may have different levels of current assets and liabilities. But you should aim for at least a ratio of 1.5.
A current ratio of 1.0 or higher indicates that a company has sufficient current assets to cover its short-term liabilities, while a ratio below 1.0 indicates that a company may be unable to meet its short-term obligations.
Ways to improve your current ratio
- Increase your liquid assets: A direct way to improve your current ratio is by increasing your company's liquid assets, such as cash and cash equivalents, by generating more revenue or reducing expenses.
- Reduce your short-term liabilities: Another way is by reducing your company's short-term liabilities, such as accounts payable or short-term debt, by negotiating better payment terms with suppliers or refinancing existing debt.
- Maintain a healthy balance in financing: Maintain a balance short-term and long-term financing. A company that relies too heavily on short-term financing, such as credit lines or trade credit, may struggle to pay its obligations when due. By using a mix of long-term and short-term financing, a company can improve its current ratio and reduce its exposure to liquidity risk.