ruly Current ratio: paying the debts due within a year
Definition of the current ratio, its formula, where to find current assets and liabilities in an annual report, usual thresholds by sector, and the traps of reading it.
Published
Definition
The current ratio divides current assets (cash, trade receivables, inventory) by current liabilities (trade payables, tax liabilities, the part of financial debt due within the year). It measures the company’s ability to meet its obligations over the next twelve months with what it has or will collect over the same period.
Formula
Current ratio = current assets / current liabilities
Where to find it in an annual report
The consolidated balance sheet splits assets and liabilities into current (due within a year) and non-current. The totals of current assets and current liabilities usually appear there directly.
Common thresholds
Value: 1.5 or more for green, from 1 to 1.5 for orange, red below 1. A very high ratio, above 3, can signal idle cash or piling inventory. Retail and restaurants often live with a ratio below 1, because their customers pay cash and their suppliers are paid later.
In the preset strategies
| Preset strategy | Criterion met | To monitor | Criterion not met |
|---|---|---|---|
| Value Current ratio | ≥ 1.5 | 1 to 1.5 | < 1 |
Pitfalls
- Inventory counts as a current asset, but it does not always turn into cash quickly: the quick ratio, which leaves out inventory, is more cautious.
- The ratio is taken on a single date, the balance sheet date, often chosen when cash is high.
- A ratio below 1 is not always a danger: a company that collects from customers before paying its suppliers normally works that way.
- Financial debt falling due within the year makes the ratio drop at once, even if its refinancing is already planned.
Where it does not apply
- Banks and insurers: their balance sheet does not split current and non-current items in the same way.
- Retail and restaurants paid in cash: a low ratio is part of the business model.
A worked example
A fictitious company, called Company P here, reports €360 million of current assets, including €120 million of inventory, and €240 million of current liabilities. Its current ratio is 360 / 240 = 1.5: green for the Value preset strategy. Without inventory, the ratio falls to (360 − 120) / 240 = 1.
Why the Value preset strategy looks at it
A discounted company is often going through a difficult period. If it cannot meet the year’s obligations, it will have to borrow on poor terms or issue shares, at the expense of shareholders. The current ratio complements net debt to EBITDA, which looks at debt over several years.
Sources
- Annual reports of listed companies (consolidated balance sheet)
- IFRS Foundation, IAS 1 (presentation of financial statements)