What does a 1.5 current ratio mean?
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The Current Ratio is a measure of a company’s near-term liquidity position, or more specifically, the short-term obligations coming due within one year. Often used alongside the quick ratio, the current ratio measures if a company can meet its short-term obligations using its short-term assets on the present date. Table of Contents
How to Calculate Current Ratio (Step-by-Step)The current ratio is categorized as a liquidity ratio since it assesses how financially sound the company is in relation to its near-term liabilities. Liquidity ratios generally have a near-term focus, hence the two main inputs are current assets and current liabilities.
The current ratio reflects a company’s capacity to pay off all its short-term obligations, under the hypothetical scenario that short-term obligations are due right now. Since the current ratio compares a company’s current assets to its current liabilities, the required inputs can be found on the balance sheet. Often, the ratio tends to also be a useful proxy for how efficient the company is at managing its working capital. Current Ratio FormulaThe formula for calculating the current ratio is as follows. Current Ratio = Current Assets ÷ Current Liabilities Simple Current Ratio Example CalculationAs a quick example calculation, let’s say a company has the following balance sheet data: Current Assets:
Current Liabilities:
With that said, the required inputs can be calculated using the following formulas.
For the last step, we’ll divide the current assets by the current liabilities.
The ratio of 1.0x is right on the cusp of an acceptable value — since if the ratio dips below 1.0x, that means the company’s current assets cannot cover its current liabilities. If the ratio were to drop below the 1.0x “floor”, raising external financing would become urgent. How to Interpret the Current RatioThe range used to gauge the financial health of a company using the current ratio metric varies on the specific industry. For instance, supermarket retailers typically have low current ratios considering their business model (and free cash flows) are essentially a function of their ability to raise more debt to fund asset purchases (i.e. increases debt on B/S), as well as pushing back supplier/vendor payments (i.e. increasing accounts payable) As a general rule of thumb, a current ratio in the range of 1.5 to 3.0 is considered healthy.
However, a current ratio <1.0 could be a sign of underlying liquidity problems, which increases the risk to the company (and lenders if applicable). Tracking the current ratio can be viewed as “worst-case” scenario planning (i.e. liquidation scenario) — albeit, the company’s business model may just require fewer current assets and comparatively more current liabilities. Here, the company could withstand a liquidity shortfall if providers of debt financing see the core operations are intact and still capable of generating consistent cash flows at high margins. But a higher current ratio is NOT necessarily always a positive sign — instead, a ratio in excess of 3.0x can result from a company accumulating current assets on its balance sheet (e.g. cannot sell inventory to customers). While under a liquidation scenario, a higher amount of asset collateral is perceived positively, most companies focus on forward-looking performance like free cash flow (FCF) generation and profit margins, although everything is linked to one another in some ways. Limitations to the Current Ratio MetricOne shortcoming of the metric is that the cash balance includes the minimum cash amount required for working capital needs. Without the minimum cash on hand for operations to continue, as usual, the business cannot continue to run if its cash were to dip below this level — e.g. the company is struggling to collect owed cash payments from customers that paid on credit. Likewise, the cash balance could contain restricted cash, which is not freely available for use by the business and is instead held for a specific purpose. Next, the inclusion of short-term investments that cannot be liquidated in the markets easily could also have been included — i.e. low liquidity and cannot sell without selling at a loss at a substantial discount. The last drawback to the current ratio that we’ll discuss is the accounts receivable amount can include “Bad A/R”, which is uncollectable customer payments, but management refuses to recognize it as such. Current Ratio vs. Quick Ratio (“Acid-Test”)Another common liquidity measure is the quick ratio, otherwise known as the “acid-test” ratio. In comparison, the quick ratio is considered a more strict variation due to filtering out current assets that are not actually liquid — i.e. cannot be sold for cash immediately. By adjusting the numerator to include solely highly liquid assets that can truly be converted into cash in <90 days with a high degree of certainty, the quick ratio is a more conservative measure of liquidity. Current Ratio Calculator – Excel Model TemplateWe’ll now move to a modeling exercise, which you can access by filling out the form below. Current Ratio Calculation ExampleSuppose we’re evaluating the liquidity of a company with the following balance sheet data in Year 1. Current Assets:
Current Liabilities:
Putting the above together, the total current assets and total current liabilities each add up to $125m, so the current ratio is 1.0x as expected. The company has just enough current assets to pay off its liabilities on its balance sheet. As for the projection period — from Year 2 to Year 4 — we’ll use a step function for each B/S line item, with the Year 1 figures serving as the starting point. Our assumptions for the changes in working capital line items are as follows. Current Assets:
Current Liabilities:
Clearly, the company’s operations are becoming more efficient, as implied by the increasing cash balance and marketable securities (i.e. highly liquid, short-term investments), accounts receivable, and inventory. From Year 1 to Year 4, the current ratio increases from 1.0x to 1.5x. Note the growing A/R balance and inventory balance require further diligence, as the A/R growth could be from the inability to collect cash payments from credit sales. The increase in inventory could stem from reduced customer demand, which directly causes the inventory on hand to increase — which can be good for raising debt financing (i.e. more collateral), but a potential red flag. Therefore, applicable to all measures of liquidity, solvency, and default risk, further diligence is necessary to understand the actual financial health of a company.  Step-by-Step Online Course Everything You Need To Master Financial ModelingEnroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks. Enroll Today Is current ratio of 1.5 good?A good current ratio is typically anywhere between 1.5 and 2, but it can sometimes depend on the industry your company falls within. A current ratio lets a company know if it has enough cash flow to pay its immediate debts and liabilities, should it become necessary.
What does a current ratio of 1.6 mean?It offers two key metrics: it tells you whether a firm can pay off its short-term debts with its short-term assets, and how much liquidity a firm has. From an investor's point of view, a ratio of between 1.6 and 2 is healthy, while ratios below 1 or well above 2 might be cause for concern.
What does a current ratio of 1.15 mean?… the current ratio is a calculation that measures how much of its short-term assets a company would need to use to pay back its short-term liabilities. … a current ratio of 1.5 or above is considered healthy, while a ratio of 1 or below suggests the company would struggle to pay its liabilities and might go bankrupt.
What does a debt to equity ratio of 1.5 mean?A debt-to-equity ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity. To illustrate, suppose the company had assets of $2 million and liabilities of $1.2 million. Since equity is equal to assets minus liabilities, the company's equity would be $800,000.
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