What is current ratio?

Current ratio (definition)

Current ratio measures a business's ability to pay all its bills and make loan repayments in the coming months. It’s a type of liquidity.

Current ratio is a broader measure of liquidity to the quick ratio. It’s also called the working capital ratio.

The current ratio formula compares current liabilities (which are amounts owed within the coming 12 months) against current assets. Current assets include cash the business has, inventory, plus payments due to come in such as receivables, and any assets that could be sold within 12 months.

Current ratio formula shows current assets divided by current liabilities equals the current ratio (or liquidity).

Current ratio liquidity formula.

What current ratio means for the business

A current ratio of 1.0 or more shows the business can cover its short-term debts and is generally healthy. However if it’s consistently very high, a business might want to consider how it could be investing more into growth and development.

A ratio of less than 1.0 is less attractive but it will happen from time to time. A growing business, for example, will be making investments and may find their current ratio drops below 1.0. Nevertheless, most businesses will want to avoid having a ratio that is permanently below 1.0.

The current ratio changes over the course of a billing cycle, so it’s a good idea to measure it at the same time every month. That way you’re comparing like for like and can see the long term trend of the current ratio.

Other liquidity ratios

Current ratio is a common way for small businesses to measure liquidity, but you may also encounter:

  1. Quick ratio (or acid test ratio): It only uses assets that can be changed into cash within three months. Cash, cash equivalents, short-term investments and receivables divided by current liabilities (debts due to be paid within three months). Or alternatively, current assets minus inventory and prepaid expenses divided by current liabilities (debts due to be paid within three months).
  2. Cash ratio: Cash and cash equivalents divided by current liabilities.

How current ratio differs from working capital, cash flow, and free cash flow

The current ratio is a measure of spending power, similar to working capital, cash flow, and free cash flow. Each of these terms has its own complexities, but here’s roughly how they compare:

  • The current ratio shows how easily a business can cover upcoming costs in the next 12 months
  • Working capital shows how much money will be left after covering those upcoming costs
  • Cash flow refers to the general availability of cash
  • Free cash flow is the amount of cash left after making capital investments

See related terms

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Disclaimer

This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.