Current ratio:
can short-term assets cover short-term bills?

A snapshot of short-term breathing room

Suppliers, banks and landlords all want the same assurance: that you can pay what you owe over the next twelve months. The current ratio gives a quick reading by setting what you expect to turn into cash within a year against what you must pay out in the same period.

It is among the first ratios anyone looks at on a balance sheet, because both inputs are printed there and no adjustments are required.

The formula and what sits in each part

Notice that it compares gross resources against gross obligations. It does not say how quickly each item converts or when each bill falls due, which matters in the cases discussed below.

A worked example

A small trading firm closes the year with the following balance sheet items.

It owns ₹1.50 of near-term resources for every ₹1 it must pay over the coming year, and the surplus of ₹1,50,000 is its working capital.

How ordinary transactions move the ratio

The ratio is sensitive to simple decisions, and sometimes in surprising directions. Using the example above:

Both outcomes follow from the same rule: when a ratio is above 1, adding the same amount to numerator and denominator pulls it down, and removing the same amount from both pushes it up.

What counts as a good number

Retailers and supermarkets can operate safely below 1 because they sell for cash quickly and pay suppliers on credit. A construction firm with long billing cycles may need a higher cushion. The figure is only useful against peers and the company's own past.

When a healthy-looking ratio hides trouble

• Inventory may be slow-moving, obsolete or hard to sell at book value, so the numerator is overstated.
• Receivables may include customers who are unlikely to pay in time.
• A loan due next month may be sitting beside a long-dated asset that cannot be sold quickly.
• Window dressing: a firm may repay payables right before the year end to improve the reported figure.

A stricter variant, the quick ratio, removes inventory so only fast-converting assets are counted. Use both together.

The rupee companion: working capital

The ratio expresses the cushion as a multiple; working capital expresses it as an amount. Subtract current liabilities from current assets and you get the surplus that funds day-to-day operations. In the example above that is ₹4,50,000 − ₹3,00,000 = ₹1,50,000.

The two views can tell different stories. A business with a ratio of 1.2 but ₹5 crore of working capital may be perfectly safe, while a business with a ratio of 2.0 and only ₹20,000 of working capital can be wiped out by one bad invoice. Look at both, and relate the amount to monthly operating costs to see how many weeks of spending the surplus really covers.

• Ratio: good for comparing companies of different sizes.
• Amount: good for judging whether the cushion is large enough in absolute terms.
• Trend: good for spotting slow deterioration that a single reading hides.

How banks and suppliers use it

Banks often write a minimum current ratio into loan agreements, commonly as a covenant that must be met at each reporting date. Falling below it can trigger a review, higher pricing or a request for fresh security. Trade suppliers use a looser version of the same test when deciding how much credit to extend.

If you are about to renew a facility, check the ratio on your last balance sheet and on the next one you expect. Timing a large payment, for example, can move the figure materially. Be careful, though: arranging payments purely to dress a reported number can mislead the people relying on it and does nothing for real liquidity.

Setting a target that fits your business

Rather than adopt a generic 2.0, derive a floor from your own cycle. List the bills due in the next three months, add a margin for delays, then ask what assets are reliably convertible in the same window. If the ratio falls under that floor, you have an early warning before it appears in a bank covenant.

Also consider timing within the month. A firm may look healthy at month end after collections come in, and stretched in the middle when salaries and rent are paid. A weekly cash view, even if rough, covers the gap that a single balance-sheet date misses.

Seasonality and the reporting date

A balance sheet is a photograph of one day. A garment exporter who ships heavily before a festival may show large receivables and little cash on the closing date, while a farm-linked business may carry its biggest stock just after harvest. The ratio on that date can differ a great deal from the average through the year.

When comparing periods, line up like with like: the same month in successive years rather than consecutive quarters. If you are presenting numbers to a lender, an average of several month-end ratios is a more honest picture than a single favourable date.

Using it for your own business or investing decisions

Before approaching a bank for a working-capital limit, compute the ratio the way the bank will, using the latest balance sheet. Before buying a share, check how the figure has trended relative to peers. A cash-flow tool can help you test what a payment or a new loan does to the ratio before you make it.