The balance sheet current ratio is one of many financial ratios that is used to assess whether or not to invest in a given company, and is the result of a concise formula from numbers that can be found on the balance sheet. The balance sheet current ratio measures a company's current assets against its current liabilities, or to be more precise, it compares the amount dollars that a company can convert to cash within one year versus the amount of debt in dollars coming due during that same year. To many, it serves as a test of a firm's financial strength.
Here you'll learn how the ratio works and how to use it in the real world to assess whether a company is doing well or poorly, so you can make informed choices about how you invest.
- The balance sheet current ratio formula compares a company's current assets to its current liabilities.
- The ratio is equal to the total amount of current assets in dollars divided by the total amount of current debts in dollars.
- 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 two is healthy, while ratios below one or well above two might be cause for concern.
What Is the Balance Sheet Current Ratio?
Current or short-term assets are those that can be converted to cash in less than one year, and also those that might be used up in a year in the course of running the company. They include market assets such as bonds or CDs, any debts they have yet to collect, and prepaid amounts (such as if future taxes were paid the year before). Any cash that a firm may have on hand is of course on the list of short-term assets as well.
By the same token, current liabilities are debts that are due within a year, and would cause a firm to convert its current assets to liquid in order to pay them off. They might include money owed in payroll and other payables, debt from bills, or unearned income (or other amounts collected ahead of time).
How To Calculate the Balance Sheet Current Ratio Using the Formula
The balance sheet current ratio can be found by dividing a company's total current assets in dollar 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 usually listed first.
For instance, if a company has $20 million in current assets and $10 million in current debt, the current ratio is two.
If they have $8 million in current assets and $10 million in current debt, the current ratio is 0.8.
If they have $50 million in current assets and $50 million in current debt, the current ratio is one.
It's so simple, yet it can express so much.
What You Can Learn From the Balance Sheet Current Ratio
The balance sheet current ratio acts as a way to gauge two aspects of a firm's financial strength:
- Short-term paying power: whether a firm can pay its short-term debts if it were to convert all of its short-term assets into cash
- Liquidity: whether a company can meet its cash needs with its current assets given its current level of debt
In most cases, a ratio of around two is though to be ideal. But not all who invest are so strict, and many regard a ratio of at least 1.6 to be on the good side, which may be more on par with today's standards.
As an investor, you should note that a current ratio may be "good" in one field and only "fair" (or poor) in another, and vice versa. The range and gauge of ratios will vary by industry due to the way each is funded, the rate at which cash cycles through, and other factors.
What It Means When the Balance Sheet Current Ratio is Low
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. When the balance sheet current ratio nears or falls below one, this means the company has a negative working capital, or in other words, more current debt than current assets. To put it simply, they're in the red. If you see a ratio near one, you'll need to take a closer look at things; this could mean it will have trouble paying its debts and may face liquidity issues.
Spotting Debt Issues
There are a few cases in which a company can have a balance sheet current ratio at or around one and still be quite healthy. This includes those that can convert their inventories to cash in a snap. (Think supplies, parts, and product that tend to be bought and sold fast, and without much hassle or need for loans.) If this is not the case, then you should be wary of such a low ratio. You should also worry if you're dealing with a company that relies on vendors to finance much of the cash, such as if they provide credit for goods that end up being sold to the end customer. If these vendors were to become concerned about the financial strength of the company, they could send business into a scramble by cutting lines of credit lines or demanding upfront payment before they sell, both of which could result in a liquidity crisis.
Think twice about investing in firms with a balance sheet current ratio of below one or well above two.
What It Means When the Balance Sheet Current Ratio is High
If you're looking at a company's balance sheet and find that the current ratio is much higher than two, this could be cause for concern (and even more so if it's three or higher). 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 instance, Microsoft had a current ratio of 3.8 in the fourth quarter of 2002. This is a massive number compared to what it needed for its daily operations. Until they paid their first dividend the next year, bought back billions of dollars worth of shares, and made a few smart acquisitions, no one knew what they were planning to do. Near the end of 2020, their current ratio sat at a much more modest 2.5.
Spotting Efficiency Issues
If you notice a large pile of cash building up and the debt has not increased at the same rate, this means a few things. First, that the money is not being borrowed. Second, that there's some growth or success at some level. Sounds like a good thing, right? Maybe, but you may want to dig deeper to find out what's going on or think twice before you invest.
The other danger of having too much cash on hand is that management might begin paying itself too highly, or they might waste the funds on things like half-formed or reckless projects, bad mergers. This is also the perfect setup for newer firms to start making risky moves. One way to check for poor or greedy board members and execs is to look for signs of good will towards the long-term owner or shareholder. The clearest sign of good will is a progressive dividend policy. The more cash the execs 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 less than prudent.
The Bottom Line
The balance sheet current ratio can be a very useful tool for getting a snapshot of a firm's financial health. It reveals two major metrics: how much they owe in debt, and whether they can pay it back without too much hassle and distills them into a single handy figure. If we take these details down to a micro level and offer you the same figure about a friend or family member, you'll have a rough notion of whether or not you'd be willing to loan them some money when they ask. Of course, that single figure is not the full picture either. You'll want to know what they plan to use the money for, whether they have a good track record of paying people back, and other such factors. The same goes when you invest at the macro level as well. Use the balance sheet current ratio as a tool, but keep in mind there may be more going on beneath the surface than what you can read from the balance sheet.