Liquidity ratios tell you about a company’s ability to meet all its financial obligations, including debt, payroll, payments to vendors, taxes, and so on. The numbers come from the Balance Sheet. The current ratio is one of the liquidity ratios. It measures a company’s ability to pay its short-term obligations. The current ratio looks at current assets (those that can be converted to cash in less than a year) and current liabilities (those that will have to be paid off in less than a year).
Using the Balance Sheet, the current ratio is calculated by dividing current assets by current liabilities:
For example, if a company’s current assets are $ 5,000 and its current liabilities are $ 2,000, then its current ratio is 2.5.
(Excerpts from Financial Intelligence, Chapter 23 – Liquidity Ratios)
This ratio can be both too low and too high. In most industries, a current ratio is too low when it is getting close to 1. At that point you are just barely able to cover the liabilities that will come due with the cash you’ll have coming in. Most bankers aren’t going to lend money to a company with a ratio anywhere near 1. Less than 1, of course, is way too low, regardless of how much cash you have in the bank. With a current ratio of less than 1, you know you’re going to run short of cash sometime during the next year unless you can find a way of generating more cash or attracting more investors.
A current ratio is too high when it suggests to shareholders that the company is sitting on its cash. Microsoft, for example, had amassed a cash horde of nearly $60 billion (yes billion) until in 2004 it announced a one-time dividend of $32 billion to its shareholders. You can imagine what its current ratio was before the dividend! (And it was probably pretty darn good after that dividend too.)
From the HBR Blog:
What is the current ratio?
It’s one of several liquidity ratios that measure whether you have enough cash to make payroll in the coming year, explains Knight. The current ratio measures a firm’s ability to pay off its short-term liabilities with its current assets. It is closely related to the quick ratio, which is often called the “acid test” because people use it to understand “if things got really ugly, could you stay afloat?” From A Refresher on Current Ratio