When analysing a company, ratios act like signposts that guide us toward its true financial health. After covering the broader ratio groups in our earlier blogs, we are now moving one step closer to detailed discussions on each ratio. In this edition, we begin with a core liquidity metric, i.e., the Current Ratio. Simple yet powerful, it offers a first look at how comfortably a company can meet its short-term needs. Join us as we unpack what the current ratio means, how to read it, and why it deserves a place in every investor’s toolkit.
The current ratio is classified as a liquidity ratio for fundamental analysis of companies. This ratio is a simple measure that shows whether a company has enough short-term assets to pay off its short-term liabilities. It is calculated by dividing current assets by current liabilities. Current assets include items that can be converted into cash within a year, such as cash and bank balances, short-term investments, inventory, and money owed by customers (debtors or trade receivables). Current liabilities, on the other hand, are payments the company must make within a year, such as money owed to suppliers (trade payables), short-term loans, upcoming interest payments, taxes payable, and other short-term expenses. Comparing these two components of the balance sheet can help investors assess whether the company can comfortably meet its short-term obligations using the resources it already owns.
A higher ratio generally means the company is in a stronger position to meet its short-term needs, while a very low ratio may signal stress. Thus, this ratio offers a quick and easy way to check the company’s immediate financial strength and liquidity before diving deeper into a more detailed analysis.
The Current Ratio is mainly calculated using a straightforward formula. However, investors often use a couple of variations depending on the level of detail they want. The core idea remains the same, i.e., to compare what the company owns in the short term with what it owes in the short term.
The formula to calculate the basic current ratio is,
Current Ratio = Current Assets / Current Liabilities
Where,
Current Assets include cash, bank balances, inventory, short-term investments, trade receivables, prepaid expenses, and other assets expected to be converted into cash within 12 months.
Current Liabilities include trade payables, short-term borrowings, current portion of long-term debt, taxes payable, accrued expenses, and other payments due within 12 months.
This formula gives a direct picture of the company’s short-term financial strength.
This ratio does not consider inventories in the current assets for the calculation of the current ratio. This is especially used when inventory is illiquid or slow-moving or by cautious investors in manufacturing or seasonal and retail sectors.
Adjusted Current Ratio = (Current Assets - Inventory) / Current Liabilities
Let us understand the calculation of the current ratio using the following example.
Consider the given data of Company A
Calculating Current Ratio
Basic Current Ratio = Current Assets / Current Liabilities
Basic Current Ratio for Year 1 = 100 / 60 = 1.67
Basic Current Ratio for Year 2 = 120 / 80 = 1.50
The ratio has fallen from 1.67 to 1.50, which means the company still has enough short-term assets to cover its short-term obligations, but its liquidity cushion has reduced slightly. Investors should further analyse why liabilities grew faster than assets or whether inventory has increased too much.
Adjusted Current Ratio = (Current Assets - Inventory) / Current Liabilities
Adjusted Current Ratio for Year 1 = (100 - 30) / 60 = 1.17
Adjusted Current Ratio for Year 2 = (120 - 50) / 80 = 0.88
Here, the trend is more worrying. The ratio drops below 1 in Year 2, indicating that without relying on inventory, the company does not have enough liquid assets to meet short-term liabilities. This signals potential liquidity pressure. Investors should explore the following cases,
Inventory is piling up,
The company is giving too much credit to customers, or
Short-term borrowings have increased.
Overall Trend and Insights for Investors
A declining current ratio, even if still above 1, signals tightening short-term financial flexibility. Moreover, a modified current ratio below 1 suggests the company may be depending heavily on inventory to stay liquid. When inventory rises much faster than sales or liabilities, it could indicate slower demand or poor working capital management. Thus, considering both versions of the ratio gives a more complete liquidity picture and better analysis.
The importance of the current ratio in the fundamental analysis of a company is highlighted below.
The current ratio is one of the easiest ways to understand whether a company can handle its short-term obligations without stress. It indicates if the business has enough readily available resources to pay upcoming bills, salaries, interest, and supplier payments. This measure acts like a first-level health check, which is similar to checking someone’s pulse before doing a full medical test. A comfortably high ratio shows stability, while a very low ratio may signal liquidity pressure.
A company may show paper profits but can still struggle with day-to-day cash needs. The current ratio reveals how smoothly the company can manage its working capital. If a company has strong liquidity, it can continue its operations without relying on emergency loans or delaying payments. This becomes especially important for businesses that often deal with long credit cycles and irregular cash collection.
A consistently low current ratio suggests higher short-term risk. It may mean the company could face delays in paying suppliers or may need more short-term borrowing. This is a useful warning signal for investors to gain deeper insights. On the other hand, a very high ratio might show the company is holding too much idle cash or slow-moving inventory, neither of which is ideal. Hence, the current ratio helps investors judge whether the company is balancing its finances well.
A stable or improving current ratio often reflects good management of cash, receivables, and inventory. A weakening ratio might point to issues like rising debt, poor inventory control, or slower customer payments. These insights help investors understand whether the company’s management is handling short-term resources efficiently.
Different industries have different working capital needs. For example, retail companies usually hold large inventories, while IT services companies hold very little. The current ratio helps investors compare companies within the same sector and understand which is managing short-term finances better. This comparison becomes very useful for investors when analysing sectors like FMCG, manufacturing, or pharma, where working capital patterns vary widely.
When combined with other ratios, the current ratio forms an important part of the fundamental analysis toolkit. It helps investors filter financially sound companies, avoid those with liquidity stress, and make more confident long-term investment decisions. Especially for retail investors investing through SIPs or directly in equities, this ratio offers clarity and reduces uncertainty.
The standard current ratio of 2:1 is broadly considered healthy for most companies when analysing them. However, this standard current ratio may vary for different industries depending on the nature of their business or the industry parameters. Some examples of the industry average current ratio are tabled below.
A current ratio below 1 can signal potential liquidity stress and the need for deeper analysis, while ratios well above 2.5 may indicate inefficient working capital management or idle assets. The key is to always compare companies within the same industry for an accurate assessment.
The current ratio provides a snapshot of the financial health of the company. However, this ratio in itself is not sufficient for an accurate analysis. Some limitations of using the current ratio include,
Does not show the quality of assets - The ratio treats all current assets as equal, but some may be slow-moving or difficult to convert into cash (like old inventory).
Can be easily inflated - A company can temporarily boost the ratio by delaying payments to suppliers or taking short-term loans just before reporting.
Ignores timing of cash flows - Even if the ratio looks good, the company may still face cash shortages if its receivables come in late.
Not useful for all industries - For sectors like banking, financial services, and telecom, the current ratio does not reflect true financial health.
A very high ratio is not always good - It may mean the company is holding too much idle cash or stock, showing inefficient use of resources.
Does not show long-term strength - The ratio only looks at short-term liquidity and cannot tell whether the company is strong in the long run.
Needs comparison with peers - The number alone means little unless compared with similar companies in the same industry.
The Current Ratio is a helpful first step in understanding a company’s short-term financial health. It shows whether the business has enough current assets to meet its short-term liabilities and helps investors judge liquidity, cash flow strength, and working capital management. When used along with other ratios and industry benchmarks, the current ratio becomes a powerful tool for investors to make more informed and confident decisions.
This article sheds light on an important liquidity ratio and kicks off our journey of breaking down ratios to provide deeper insights into the fundamental analysis of stocks. Let us know your thoughts on this topic or if you need further information on the same, and we will address it soon.
Till then, Happy Journey!
Read More: Solvency Ratio - What are they and what do they say?
Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
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