Current Ratio

What is Current Ratio?

The formula is straightforward: current assets divided by current liabilities. Both numerator and denominator depend entirely on the current/non-current classification in IAS 1.66–76A. An asset is current when the entity expects to realise it within twelve months (or within its normal operating cycle if longer), holds it primarily for trading, classifies it as cash, or has no restriction preventing realisation within twelve months. A liability is current when the entity expects to settle it within twelve months, holds it for trading, does not have an unconditional right to defer settlement beyond twelve months, or is part of the entity's normal operating cycle.

The 2024 amendments to IAS 1 tightened the rules for liabilities subject to covenants. A term loan with a covenant tested after the reporting date remains non-current if the entity complied at the balance sheet date, but new disclosure requirements under IAS 1.72A force the entity to explain the covenant risk. Misclassifying even one material liability shifts the denominator and can move the ratio from above a covenant threshold to below it.

Auditors testing the current ratio are not auditing the ratio itself. They are auditing the classification of assets and liabilities that produce it. ISA 520.5 requires the auditor to develop an expectation of the ratio when using analytical procedures and to investigate significant differences from that expectation. A current ratio that has moved from 1.8 to 1.1 year-on-year is a signal, not a conclusion. The auditor traces the movement to its components: did receivables increase because collections slowed, or did current liabilities spike because a loan was reclassified?

Worked example: Rossi Alimentari S.p.A.

Client: Italian food production company, FY2025, revenue €67M, IFRS reporter. The engagement team is performing analytical procedures on Rossi's liquidity position. The bank facility agreement requires a minimum current ratio of 1.25 at each reporting date.

Step 1 — Extract the classified balances: Rossi's draft statement of financial position shows current assets of €24.6M (inventories €9.1M, trade receivables €11.2M, prepaid expenses €0.8M, cash €3.5M) and current liabilities of €18.9M (trade payables €10.4M, current portion of bank loans €5.8M, tax liabilities €1.4M, other current liabilities €1.3M).

Documentation note: record the source of each balance (trial balance reference, sub-ledger reconciliation). Confirm that the current/non-current split follows IAS 1.66–76A. Cross-reference to the fixed-asset register for any items that may have been misclassified.

Step 2 — Calculate the ratio: €24.6M divided by €18.9M produces a current ratio of 1.30.

Documentation note: record the calculation and compare to the prior year (FY2024: 1.52). Note the decline of 0.22 and flag for investigation under ISA 520.5.

Step 3 — Investigate the year-on-year movement: The decline is driven by a €3.2M increase in the current portion of bank loans (a tranche originally classified as non-current matured within twelve months of the reporting date) and a €1.8M reduction in cash used to fund a warehouse expansion. Trade receivables increased by €2.1M, but receivable days extended from 48 to 61 days, suggesting slower collections rather than revenue growth alone.

Documentation note: document the root causes of the ratio movement. For the loan reclassification, verify the maturity schedule against the bank facility agreement. For the receivable increase, assess whether the provision matrix for expected credit losses reflects the extended collection period.

Step 4 — Assess covenant compliance: The current ratio of 1.30 exceeds the 1.25 covenant threshold by a margin of 0.05. The team performs a sensitivity analysis: reclassifying €1.0M of receivables from current to non-current would reduce the ratio to 1.25, leaving zero headroom. The team verifies that no receivables are due beyond twelve months.

Documentation note: record the covenant threshold and the headroom calculation. Attach the sensitivity analysis. Document the disclosure requirement under IAS 1.72A if the margin is narrow enough that a reasonably possible change in circumstances could trigger a breach within twelve months.

Conclusion: the ratio of 1.30 is defensible because the current/non-current classification ties to verified maturity dates and the receivable ageing supports current treatment. The narrow covenant headroom is documented with a sensitivity analysis.

What reviewers and practitioners get wrong

• Teams frequently accept the current ratio at face value without testing the classification of the balances that produce it. A receivable due in 18 months is non-current regardless of management's expectation of early collection, because IAS 1.66 bases classification on contractual terms. Misclassifying such a receivable as current inflates the numerator and overstates liquidity.
• Covenant compliance testing often stops at confirming the ratio exceeds the threshold. ISA 570.16 requires the auditor to evaluate whether events or conditions exist that may cast significant doubt on going concern, and a current ratio sitting just above a covenant trigger with deteriorating receivable quality is exactly the kind of condition that demands further analysis. Documenting the ratio without documenting the headroom and the trajectory is incomplete.

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