Current ratio and gross margin calculator

Enter five lines: current assets, current liabilities, inventory, revenue and cost of goods sold. The first three come off the balance sheet, the last two off the income statement. The calculator returns the current ratio, the quick ratio, the gross profit in money and the gross margin as a percentage.

The two kinds of line are measured differently, and mixing them is the easiest way to get a wrong number out of this page. A balance sheet is a photograph taken on one date, so the first three are the position on that date and nothing else. An income statement covers a stretch of time, so revenue and cost of goods sold have to be read off the same stretch as each other. A year of revenue against a quarter of cost is not a margin.

The first two ratios ask one question in two ways. Can the company pay what falls due in the next year out of what it already holds? The current ratio counts everything short-term it owns. The quick ratio asks the same thing after removing the one current asset that has to be sold to somebody before it turns into cash.

Gross margin asks something different. Of every dollar of sales, how much survives the direct cost of making that sale? What is left has to cover wages, rent, marketing, interest and tax, and whatever remains after all of that is profit.

The gap between the current ratio and the quick ratio is the part worth looking at, and the third worked example below is built around it. So is the gap between one industry and another, which is why a single number lifted out of context tells you very little.

$$\text{CR} = \frac{CA}{CL} \qquad \text{QR} = \frac{CA - I}{CL} \qquad \text{GM} = \frac{R - C}{R}$$

Gross margin comes out of that as a decimal, the same form the formula box above uses, so multiply by $100$ to quote it as a percentage. Every input is a line a company already publishes.

Current means due to turn into cash, or due to be paid, within a year, or within the company's operating cycle where that runs longer than a year. A shipbuilder whose boats take eighteen months to build uses the longer cycle. Published accounts under the US and the international standards alike show that split on the face of the balance sheet, so you are reading the company's own classification rather than sorting the lines yourself. Banks and insurers are the standing exception. They order the balance sheet by liquidity instead and publish no current total at all, so there is no current ratio to read off one, and their liquidity is measured with a different set of tools.

Current assets are usually cash, short-term investments, money customers owe, inventory and prepayments. Current liabilities are usually money owed to suppliers, accrued wages and tax, the next twelve months of loan repayments, and anything drawn on a credit line. Current assets minus current liabilities is working capital, the same comparison written as a subtraction rather than a division. The ratio travels better between companies of different sizes, which is why it is the one that gets quoted.

Gross profit is revenue minus cost of goods sold, and cost of goods sold means the cost that only exists because the sale happened: the goods themselves, the freight in, the direct labour that made them, the hosting bill for the accounts a software firm signed up. The factory manager's salary, the office lease and the sales team sit below that line, not in it.

Every current asset is supposed to become cash within the year. Inventory is the one where that has to be arranged.

Cash is already cash. Money customers owe usually arrives on its own, and if it does not, the company can chase it or sell the receivable. Inventory has to be sold first, to a buyer who wants it, at something near the price the balance sheet assumed. Any of those can fail:

• The buyer may not appear at that price. A company that has to clear stock in a hurry clears it at a discount, and a forced sale is exactly the situation the quick ratio is asking about.
• Stock goes stale. Fashion, food and anything with a version number lose value on a clock the balance sheet does not show.
• Some of it is not finished. Raw materials and work in progress are counted at cost and cannot be sold as they are.
• Some of it can never be sold separately. Spare parts held so a production line can keep running have to stay on the shelf.

So the quick ratio, sometimes called the acid test, values inventory at zero for the purpose of paying the bills that fall due over the next year. That is deliberately harsh. Real inventory is not worthless, and a business that turns its stock over in a week is not in the same position as one that turns it over once a year. The honest reading is that the true short-term position sits somewhere between the two ratios, closer to the quick ratio the slower and more specialised the stock is.

Prepayments are weaker still, and for a different reason. Inventory can at least be sold to somebody; a year of rent paid up front is consumed rather than converted, so it never becomes cash at all. It is usually small enough that dropping it barely moves the number, which is why the common $(CA - I)/CL$ version leaves it in, while the stricter form of the same ratio counts only cash, short-term investments and money customers owe. Either is defensible. Using one on the company and the other on its competitor is not. If a company has paid three years of rent in advance, use the stricter form. What you are trying to build is the pile of assets that could actually meet a bill next month, which is the same question the guide to what liquidity means works through from the other direction.

There is no ratio on this page that has a right answer on its own.

A grocer holds a lot of inventory, sells it in days, takes cash at the till and pays its suppliers weeks later. It runs a low gross margin on high volume, and it runs a quick ratio well below 1 as a matter of course, because supplier credit is funding the shelves. That is the business model working, not a warning.

A software firm holds almost no inventory, so its quick ratio and its current ratio are nearly the same number. Its gross margin is high because the second copy of the product costs almost nothing to make, and most of its cost base sits below the gross profit line in salaries. High margin does not mean high profit. A firm at 85 percent gross margin that spends everything below the line on engineers and sales can easily lose money, and the second and third worked examples show the two shapes side by side.

Compare a company with itself a year ago, and with companies doing the same work. A current ratio that has fallen from 1.80 to 1.10 in four quarters says something. The same 1.10 read cold says almost nothing until you know what the company sells.

Two other numbers change the reading again. How much fixed cost sits below the gross profit line decides how much volume the margin has to cover, which is what the break-even calculator works out. How much of the balance sheet is borrowed decides how much room there is for a bad quarter, which is the leverage ratio. Neither is visible in a current ratio, and both change what one is worth.