What Is the Current Ratio?

What Is the Current Ratio?

The current ratio is a liquidity ratio that measures a company's ability to pay short-term or one-year obligations. It explains to investors and analysts how a company can optimize its current assets on its balance sheet in order to pay off its current debt and other payables.

When a company's current ratio is very high in comparison to its peer group, it indicates that management may not be utilizing its assets efficiently.

The current ratio is so-called because, unlike other liquidity ratios, it includes all current assets and liabilities. The current ratio is also known as the working capital ratio.

Current Ratio Formula and Calculation

Analysts compute the ratio by comparing a company's current assets to its current liabilities.

On a balance sheet, current assets include cash, accounts receivable, inventory, and other current assets (OCA) that are expected to be liquidated or converted into cash in less than one year.

Accounts payable, wages, taxes payable, short-term debts, and the current portion of long-term debt are examples of current liabilities.

Current Ratio = Current liabilities/Current assets

Analyzing the Current Ratio

The current ratio assesses a company's ability to pay current, or short-term, liabilities (debts and payables) with current, or short-term, assets (cash, inventory, and receivables).

In many cases, a company with a current ratio of less than 1 the capital on hand to meet its short-term obligations if they were all due at the same time, whereas a current ratio greater than 1 indicates that the company has the financial resources to remain solvent in the short term. However, because the current ratio is only a snapshot at any given time, it is rarely an accurate representation of a company's short-term liquidity or long-term financial health.

For example, a company's current ratio may be very high, but its accounts receivable may be very old, possibly because its customers pay slowly, which may be hidden in the current ratio. Some of the receivables may even have to be written off. Analysts must also consider the quality of a company's other assets in relation to its obligations. If the inventory cannot be sold, the current ratio may appear acceptable at one point in time, even if the company is on the verge of bankruptcy.

 

How Is the Current Ratio Determined?

It is very simple to calculate the current ratio: Simply divide the current assets by the current liabilities of the company. Current assets are those that can be converted into cash within a year, whereas current liabilities are those that are due within a year. Cash, inventory, and accounts receivable are examples of current assets. Accounts payable, wages payable, and the current portion of any scheduled interest or principal payments are examples of current liabilities.

 

What Is an Appropriate Current Ratio?

What constitutes a good current ratio will vary depending on the industry and historical performance of the company. Current ratios of 1.50 or higher would indicate adequate liquidity.

 

What if the current ratio is less than one?

A current ratio less than one could indicate that a company may struggle to meet its short-term obligations, whereas ratios greater than one could indicate that the company is doing well.

 

What Is a Current Ratio of 1.5?

A current ratio of 1.5 means that the firm has INR 1.50 in current assets for every INR 1 in current liabilities. Assume a company's current assets are INR 50,000 in cash and INR 100,000 in accounts receivable. Meanwhile, its current liabilities include INR 100,000 in accounts payable.