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# What Is a Good Current Ratio?

## What Is the Current Ratio?

The current ratio is one of the several liquidity ratios that can be used to evaluate a company’s short-term liquidity, or in other words, the company’s ability to pay down short-term obligations.

Short term obligations include those that are expected to be due within one year such as short-term bank loans, accounts payable, wages, and lease payments.

The current ratio is also often called working capital ratio and describes the relationship between a company’s assets that can be converted within one year and the liabilities that are to be paid within one year.

You can calculate the current ratio by dividing the current assets of its business by the current liabilities.

Current assets are cash & cash equivalents or other assets of a company that are expected to be converted into cash within one year. Examples of current assets include accounts receivable, inventors, and prepaid expenses.

Current liabilities are short-term financial obligations that are expected to be due within one year such as short-term bank loans, accounts payable, wages, and lease payments.

Both current assets and current liabilities are standard figures that can quickly be found on a company’s balance sheet.

## Example: Microsoft

Here is a screenshot of Microsoft’s balance sheet from the 10-K report for the fiscal year of 2020.

Right on the upper part of the balance sheet, we can see that Microsoft has \$181.915B in total current assets. A few lines below are total current liabilities of about \$72.310B.

Dividing the current assets by the current liabilities (181.915 / 72.310B) would lead us to a current ratio of approximately 2.52 for Microsoft in the fiscal year that ended in June 2020.

A higher number in current assets would automatically result in a higher current ratio if current liabilities had stayed equal.

A current ratio of above 1 indicates that the business has enough money in the short term to pay its obligations, while a current ratio below 1 suggests that the company may run into short-term liquidity issues.

## What’s a Good Current Ratio?

In general, a current ratio between 1.5 to 2 is considered beneficial for the business, meaning that the company has substantially more financial resources to cover its short-term debt and that it currently operates in stable financial solvency.

An unusually high current ratio may indicate that the business isn’t managing its capital efficiently to generate profits.

On the other hand, a lower current ratio (especially lower than 1) would signify that the company’s current liabilities exceed its current assets and that the business may not be able to cover its short-term debt (if it were due all at once) with its current financial resources.

Either way, there is no clear line between what makes a current ratio good or bad because companies within different industry groups will also have different standards of current ratios. This is why it’s important to compare the current ratio of a company with its industry peers rather than treating all types of companies the same.

If a company’s current ratio is considerably below the industry average, you may want to investigate which factor is leading to that outcome. The same goes for companies that have substantially higher current ratios than their industry peers since that should also raise questionable concern.

You can also assess whether a current ratio is “good” or “bad” by analyzing how it has changed throughout the past years. A steadily increasing current ratio would show that a company is on its way to improve its liquidity, while a declining record of current ratios could presume that the company’s financial stability is worsening from time to time.

This approach may give you a much better picture of a company’s short-term liquidity instead of just looking at one current snapshot of a company’s balance sheet.

## How Important Is the Current Ratio?

The current ratio is a great ratio that quickly gauges the current financial health and well-being of a company. It can also give you a reflection of how well a company’s administration is managing working capital.

That being said, using the ratio alone will not likely be sufficient to assess a company’s short-term liquidity. The current ratio accounts for all the current assets of a company without considering that some assets may be harder to convert into cash than others. Inventory for instance, is usually more difficult to convert into cash than accounts receivable.

This may lead to a company’s liquidity position that would look more attractive than other companies even if that isn’t necessarily the case.

And because the current ratio only expresses the financial position of a company at the current time, it mostly won’t give you a complete picture of a company’s liquidity or solvency.

In general, there is not one single ratio that will reflect all the necessary information on a company’s financial health.

Because of that, you may want to use other common liquidity ratios in addition to the current ratios such as:

• The quick ratio, which is similar to the current ratio but only takes more liquid current assets to compare it with current liabilities.
• The cash ratio, which is the most conservative one. It only compares the cash and cash equivalents to a company’s short term obligations.
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