Current Ratio
Current Ratio
A liquidity ratio that measures a company's ability to pay short-term obligations, calculated as Current Assets ÷ Current Liabilities. A ratio above 1.0 indicates sufficient assets to cover liabilities due within one year; below 1.0 may signal financial stress. Widely used in fundamental analysis and credit evaluation.
A company with $500,000 in current assets (cash, receivables, inventory) and $250,000 in current liabilities (payables, short-term debt) has a current ratio of 2.0, indicating strong short-term liquidity with twice the assets needed to cover obligations.
Students often confuse which accounts are "current" (due within one year) versus long-term, or misinterpret a very high ratio (above 3.0) as always positive when it may indicate inefficient use of assets.
How This Is Tested
- Calculating current ratio from balance sheet data showing current assets and current liabilities
- Interpreting whether a given current ratio indicates adequate liquidity or potential financial distress
- Comparing current ratios across companies to assess relative short-term financial health
- Identifying which balance sheet items are classified as current assets versus current liabilities
- Understanding the relationship between current ratio and working capital (both measure liquidity)
Calculation Example
Current Ratio = Current Assets ÷ Current Liabilities - Identify total current assets: $750,000
- Identify total current liabilities: $500,000
- Divide current assets by current liabilities: $750,000 ÷ $500,000
- Calculate the ratio: 1.50
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Healthy liquidity benchmark | 1.0 or higher | Ratio above 1.0 indicates current assets exceed current liabilities |
| Strong liquidity position | 2.0 or higher | Conservative benchmark indicating company can cover short-term obligations twice over |
| Potential financial stress | Below 1.0 | Current liabilities exceed current assets, may signal difficulty meeting obligations |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Jessica, a credit analyst at an investment advisory firm, is evaluating the short-term financial health of three potential corporate bond issuers. Company A has a current ratio of 0.85, Company B has a current ratio of 1.60, and Company C has a current ratio of 3.20. All three companies operate in the same industry with similar business models. From a liquidity perspective, which company presents the LEAST credit risk?
B is correct. Company B, with a current ratio of 1.60, demonstrates adequate liquidity (well above the 1.0 minimum) while efficiently using assets. This balance indicates the company can comfortably meet short-term obligations without holding excessive idle current assets.
A is incorrect because a current ratio of 0.85 (below 1.0) signals potential financial stress, as current liabilities exceed current assets by 18%. This presents HIGHER credit risk, not lower. C is incorrect because while Company C has strong liquidity (3.20), an exceptionally high current ratio may indicate inefficient capital deployment or excess inventory that could become obsolete. The highest ratio isn't always best. D is incorrect because current ratios below 1.0 are generally concerning regardless of company maturity, as they indicate insufficient assets to cover near-term obligations.
The Series 65 exam tests your ability to interpret financial ratios in context, particularly for suitability analysis when recommending fixed-income securities. Understanding that current ratio evaluation requires balance (not too low, not excessively high) is critical for assessing credit risk and making appropriate bond recommendations to clients.
What does a current ratio of 1.0 indicate about a company's short-term financial position?
A is correct. A current ratio of 1.0 means current assets exactly equal current liabilities. This represents the minimum threshold for adequate liquidity, where the company has just enough short-term assets to cover short-term obligations.
B is incorrect because a ratio of 2.0, not 1.0, indicates twice as many current assets as current liabilities. C is incorrect because it reverses the relationship; when current liabilities exceed current assets, the ratio would be below 1.0 (for example, 0.80 or 0.90). D is incorrect because the current ratio measures short-term assets versus short-term liabilities (both due within one year), not the company's ability to cover annual operating expenses.
The Series 65 exam frequently tests knowledge of fundamental financial ratios and their interpretation. Understanding what a current ratio of 1.0 represents (the break-even point for short-term liquidity) is essential for evaluating whether a company can meet its near-term obligations, which directly impacts suitability recommendations for equity and fixed-income securities.
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Access Free BetaAn analyst reviews a company's balance sheet and finds the following: cash $120,000, marketable securities $80,000, accounts receivable $200,000, inventory $150,000, accounts payable $180,000, and short-term notes payable $120,000. What is the company's current ratio?
C is correct. Calculate current assets: $120,000 (cash) + $80,000 (marketable securities) + $200,000 (accounts receivable) + $150,000 (inventory) = $550,000. Calculate current liabilities: $180,000 (accounts payable) + $120,000 (short-term notes payable) = $300,000. Current ratio = $550,000 ÷ $300,000 = 1.83.
A (1.25) incorrectly calculates current assets as $375,000, perhaps excluding inventory from current assets (a common error). B (1.50) incorrectly uses $450,000 as current assets, possibly excluding one component or miscalculating the sum. D (2.00) incorrectly uses $600,000 as current assets or $275,000 as current liabilities, representing calculation errors in totaling the balance sheet items.
Current ratio calculations appear on the Series 65 exam as part of fundamental analysis questions. The most common mistakes include forgetting to include all current asset categories (especially inventory or marketable securities) or misclassifying which items are current versus long-term. Accurate calculation is essential for evaluating corporate securities and making suitable recommendations.
All of the following statements about the current ratio are accurate EXCEPT
C is correct (the EXCEPT answer). A current ratio below 1.0 does NOT always indicate imminent bankruptcy. While it signals potential liquidity concerns (current liabilities exceed current assets), many factors affect solvency including cash flow from operations, access to credit lines, asset quality, and industry norms. Some highly efficient companies (especially in retail with fast inventory turnover) operate successfully with current ratios below 1.0.
A is accurate: The current ratio specifically measures short-term liquidity by comparing assets and liabilities due within one year. B is accurate: Current assets typically include cash, cash equivalents, marketable securities, accounts receivable, and inventory (all convertible to cash within one year). D is accurate: The formula is Current Assets ÷ Current Liabilities, producing a ratio that indicates how many dollars of current assets exist for each dollar of current liabilities.
The Series 65 exam tests your ability to interpret financial ratios with appropriate nuance. Understanding that a current ratio below 1.0 is concerning but not necessarily catastrophic (and varies by industry) prevents overly simplistic analysis when evaluating securities for client portfolios. Context matters in fundamental analysis.
A manufacturing company reports current assets of $800,000 and current liabilities of $500,000, resulting in a current ratio of 1.60. Which of the following statements about this company's liquidity position are accurate?
1. The company has $1.60 in current assets for every $1.00 of current liabilities
2. The company's working capital is $300,000
3. The current ratio indicates the company can cover short-term obligations
4. If current liabilities increase to $600,000 with no change in current assets, the new current ratio would be 1.33
D is correct. All four statements (1, 2, 3, and 4) are accurate.
Statement 1 is TRUE: A current ratio of 1.60 means exactly this: $1.60 of current assets for every $1.00 of current liabilities. This is the literal interpretation of the ratio.
Statement 2 is TRUE: Working capital = Current Assets - Current Liabilities = $800,000 - $500,000 = $300,000. Working capital and current ratio both measure liquidity but express it differently (dollar amount vs. ratio).
Statement 3 is TRUE: A current ratio of 1.60 (above the 1.0 minimum threshold) indicates the company has sufficient current assets to cover current liabilities, suggesting adequate short-term liquidity.
Statement 4 is TRUE: New current ratio = $800,000 ÷ $600,000 = 1.33. The ratio decreases because the denominator (current liabilities) increased while the numerator (current assets) remained constant, demonstrating how rising obligations without corresponding asset increases weakens liquidity.
The Series 65 exam tests comprehensive understanding of liquidity metrics, including the relationship between current ratio and working capital, how to interpret ratio values, and how changes in balance sheet components affect the ratio. This multi-dimensional analysis is essential for evaluating corporate securities and understanding credit risk when making investment recommendations.
💡 Memory Aid
Think of the "Dollar-for-Dollar Coverage Test": Current Ratio shows how many dollars of current assets (stuff you can turn into cash within a year) you have for each dollar of current liabilities (bills due within a year). Above 1.0 = Safe (you can pay your bills), Below 1.0 = Stress (bills exceed resources).
Related Concepts
This term is part of this cluster: