The current ratio and the quick ratio
Current ratio = current assets ÷ current liabilities
Quick ratio = (cash + marketable securities + receivables) ÷ current liabilities
Cash ratio = (cash + marketable securities) ÷ current liabilities
Current assets are cash, short-term investments, receivables, inventory and prepaid items; current liabilities are payables, accrued expenses, the portion of debt due within a year, and customer deposits. The three ratios differ in how optimistic they are about what will turn into cash: the current ratio counts everything, the quick ratio excludes inventory, which has to be sold first, and the cash ratio counts only what is cash already. Working capital, the difference rather than the ratio, is the dollar cushion: current assets minus current liabilities.
Worked example: Northfield Tools (illustrative)
| Balance sheet line | $m |
|---|---|
| Cash and equivalents | 120 |
| Receivables | 310 |
| Inventory | 265 |
| Other current assets | 25 |
| Current assets | 720 |
| Accounts payable | 210 |
| Accrued expenses | 90 |
| Debt due within a year | 50 |
| Other current liabilities | 50 |
| Current liabilities | 400 |
Northfield Tools, the fictional industrial company in these guides, has a current ratio of 720 ÷ 400 = 1.8×, a quick ratio of (120 + 310) ÷ 400 = 1.1×, a cash ratio of 0.3× and working capital of $320 million. Read together: the company can meet a year's obligations from its liquid assets even if it sold no inventory, but not from cash alone, which is normal. The gap between 1.8× and 1.1× is the inventory, and whether that is a comfortable cushion or a warehouse of unsold stock is the question the ratio cannot answer by itself; the how to read a 10-Q article shows the same company's inventory growing faster than its sales.
What a good number looks like
For a typical manufacturer or distributor, a current ratio between about 1.5× and 2× is comfortable, and a quick ratio around 1× means the company could pay its bills without selling inventory. Below 1× the company depends on collecting and selling faster than it pays, or on rolling over short-term debt, which works until a lender or a customer changes its mind. Above about 3× the company may simply be holding too much cash or inventory, capital that could be returned or invested.
But the level depends on the business model, and some of the best businesses run below 1× on purpose. A grocer sells its stock for cash days before it pays the supplier; a subscription company collects a year's fees in advance and books them as a current liability it will never have to repay in cash; a restaurant has almost no receivables and little inventory. Their current ratios of 0.6× or 0.8× reflect customers funding the business, not distress. The question is always whether the pattern is structural and stable, or new.
A useful habit is to ask what would happen if the company could not borrow for a year. If the answer is that it would pay its bills from collections and cash and carry on, the liquidity is adequate whatever the ratio says; if the answer is that it would have to sell assets or delay suppliers, the ratio is flattering it.
The cash conversion cycle behind the ratio
The current ratio is a snapshot of a process: cash goes into inventory, inventory becomes a receivable when sold, the receivable becomes cash when collected, and suppliers are paid somewhere along the way. Three measures time the stages, using Northfield's $1,500 million of revenue and $975 million of cost of sales:
| Measure | Formula | Northfield |
|---|---|---|
| Days sales outstanding | Receivables ÷ revenue × 365 | 310 ÷ 1,500 × 365 = 75 days |
| Days inventory outstanding | Inventory ÷ cost of sales × 365 | 265 ÷ 975 × 365 = 99 days |
| Days payables outstanding | Payables ÷ cost of sales × 365 | 210 ÷ 975 × 365 = 79 days |
| Cash conversion cycle | DSO + DIO − DPO | 95 days |
Northfield has cash tied up for about 95 days between paying for materials and collecting from customers, which is why it needs working capital and why its receivables and inventory are the largest items on the balance sheet. A lengthening cycle, especially receivables days rising while sales are flat, is the earliest sign of customers paying slowly or sales being pulled forward, and it shows up in these figures a quarter or two before it shows up in profit. The free cash flow formula article shows the same movement as the working-capital line of the cash flow statement.
Traps, and using the ratio in a screen
- Assets that are not current. Receivables from a customer in trouble and inventory nobody wants are current assets until they are written off. Check the allowance for doubtful accounts and the inventory turnover.
- Season. A retailer's ratio in January, after the holiday sales, looks nothing like October's, when the shelves are full. Compare the same quarter year on year.
- Debt moving into the current column. A bond with eleven months to maturity suddenly appears in current liabilities and the ratio drops; the real question is whether it can be refinanced.
- A high ratio from inactivity. Cash piling up and inventory not moving both raise the ratio while saying nothing good.
In a stock screen, liquidity is a floor rather than a target: a current ratio above about 1.2× and a quick ratio above about 0.8× for industrial companies, relaxed for business models that collect before they pay, and paired with the leverage tests in the net debt to EBITDA and debt to equity ratio articles. A company that passes the leverage tests and fails the liquidity one is usually living on short-term borrowing, which is the pattern the value trap article warns about. VALYSTR's screener computes these from each company's filed balance sheet.
Screen on liquidity and leverage together
Add current and quick ratio floors beside leverage limits in the screener, with figures taken from each company's filed balance sheet.
Frequently asked questions
What is a good current ratio?
For a typical manufacturer or distributor, between about 1.5× and 2×, with a quick ratio near 1×. Below 1× needs an explanation, and businesses that collect from customers before paying suppliers, such as grocers and subscription companies, run below 1× safely by design. Above 3× often means cash or inventory sitting idle. Compare within an industry and watch the trend.
What is the difference between the current ratio and the quick ratio?
The current ratio counts all current assets, including inventory and prepaid expenses; the quick ratio counts only cash, marketable securities and receivables, the assets that can be turned into cash without first making a sale. The gap between the two is mostly inventory, and a large gap means the company's liquidity depends on selling what it holds.
Is a current ratio below 1 always bad?
No. It means current liabilities exceed current assets, which is risky for a company that must pay suppliers before it collects from customers, but normal for one that collects first. Grocers, restaurants and subscription businesses run below 1× because customers fund their working capital. Judge the ratio against the business model and the trend.
How do you calculate working capital?
Subtract current liabilities from current assets. A company with $720 million of current assets and $400 million of current liabilities has $320 million of working capital. The ratio form, 1.8×, is better for comparing companies of different sizes; the dollar form shows the cushion in absolute terms and the amount that grows as the business grows.
What is the cash conversion cycle?
The number of days between paying for inputs and collecting cash from customers: days sales outstanding plus days inventory outstanding minus days payables outstanding. A cycle of 95 days means cash is tied up for about three months per turn. A lengthening cycle is an early warning of slow collections or unsold inventory; a negative cycle means customers fund the business.