What Is the Balance Sheet Current Ratio Formula?
How to Calculate the Balance Sheet Current Ratio Formula
The balance sheet current ratio formula is a financial ratio that measures dollars in company assets that are convertible to cash within one year relative to debts coming due during that same year. It serves as a test of a firm's financial strength.
Learn how the ratio works through an example and how to use it as an investor to evaluate the financial strength of a business.
What Is the Balance Sheet Current Ratio Formula?
Current or short-term assets are those that can be converted to cash in less than one year, such as cash, marketable securities like government bonds or certificates of deposit, short-term receivables, and prepaid amounts like taxes. Similarly, current liabilities are those that require a firm to liquidate its current assets within a year, such as payables and unearned income (amounts collected in advance).
How Do You Calculate the Balance Sheet Current Ratio Formula?
The current ratio amounts to a company's total current assets in dollars divided by its total current liabilities in dollars. Both total current assets and total current liabilities are listed on a standard balance sheet, with current assets typically appearing before current liabilities.
For example, if a company has $20 million in current assets and $10 million in current liabilities, the current ratio is 2.
How the Balance Sheet Current Ratio Formula Works
The current ratio acts as a barometer of two aspects of a firm's financial strength:
- Short-term paying ability: The balance sheet current ratio formula indicates whether a firm can pay its short-term debts by converting its short-term assets into cash.
- Liquidity: The current ratio formula also signals whether a company can meet its cash needs with its current assets given its current liabilities.
What you, as an investor, should consider an acceptable current ratio varies by industry because different types of enterprises have different cash-conversion cycles, economic needs, and funding practices.
In general, a ratio of around 2 is considered ideal. However, a ratio of at least 1.6 is regarded as favorable and may be more realistic for companies today.
Spotting Debt Repayment or Liquidity Issues
The more liquid the current assets, the smaller the balance sheet current ratio can be without cause for concern. Indeed, companies with shorter operating cycles tend to have smaller ratios. But as the balance sheet current ratio approaches or falls below 1, meaning the company has a negative working capital or greater current liabilities than current assets, you'll need to take a close look at the business; it may have trouble paying its short-term debts and may face liquidity issues.
As such, companies that have ratios around or below one should ideally only be those that have inventories that can immediately be converted into cash. If this is not the case, you should be concerned; especially when dealing with a business that relies on vendors financing much of the cash by providing credit for goods ultimately sold to the end customer. If the vendors were to become concerned about the financial strength of the corporation, they could send the business into a scramble by reducing credit lines or refusing to sell without upfront payment, resulting in a liquidity crisis.
Think twice about investing in companies with a balance sheet current ratio of below 1 or well above 2.
Gauging Investment Inefficiency
If you're analyzing a balance sheet and find a company that has a balance sheet current ratio formula is considerably higher than 2 (particularly if it's 3 or higher), that could be concerning. Even if the firm can pay its debts a few times over by converting its assets into cash, a number that high suggests that management has so much cash on hand that they may be doing a poor job of investing it.
For example, Microsoft had a current ratio of 3.8 in the fourth quarter of 2002, a massive number compared to what it needed for its daily operations. Until the company paid its first dividend the following January, bought back billions of dollars worth of shares, and made strategic acquisitions, no one knew what they were planning to do. As of November 2020, their current ratio for the fourth quarter of 2020 sits at a more moderate 2.5.
It's important to read the annual report, 10K, and 10Q of a company because executives often discuss their plans in these reports. If you notice a large pile of cash building up and the debt has not increased at the same rate (meaning the money is not borrowed), you may want to dig deeper to find out what's going on or reconsider it as an investment.
The other danger of having too much cash on hand is that management will begin compensating itself too highly and squander the funds on bad projects, terrible mergers, or high-risk activities. One defense against this, and a sign that management is on the side of the long-term owner, is a progressive dividend policy. The more cash the executives send out the door and put in your pocket as a sort of rebate on your purchase price, the less money they have sitting around to tempt them to do something questionable.
- The balance sheet current ratio formula is a financial ratio that measures current assets relative to current liabilities.
- It's calculated by dividing total current assets in dollars by total current liabilities in dollars.
- It's an indicator of financial strength that tells you how easily a firm can pay off its short-term liabilities with its short-term assets and how much liquidity it has.
- A ratio of between 1.6 and 2 is a positive from the point of view of the investor, whereas ratios below 1 or well above 2 should give investors cause for concern.