What Is Current Ratio (Explained: All You Need To Know)

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What Is Current Ratio

The current ratio is a financial measure allowing you to assess a company’s ability to pay for its short-term obligations that are due within the next twelve months.

The current ratio is a liquidity ratio allowing companies and analysts to determine how well the company can pay for its short-term debt and obligations.

If the current ratio is too high, the company may not be using its assets efficiently to increase its overall return.

If the current ratio is too low, it means that the company there’s a higher risk that the company may have liquidity issues and could not pay its short-term debt.

Typically, companies strive to maintain a current ratio that is within the industry average.

The current ratio is a ratio that includes all of the company’s current assets and liabilities, such as cash, marketable securities, accounts receivables, short-term debt, accounts payable, and so on.

Any asset that can be turned into cash within a year will be included in the current ratio.

Similarly, any liability or debt that must be paid within a year will be included as well.

Let’s look at what current assets and current liabilities tend to include.

Current Assets

The current assets refer to any resource available to the company that is readily convertible into cash within less than one year.

Here are a few examples of what current assets can include:

• Cash
• Cash equivalents
• Marketable securities
• Accounts receivable
• Notes receivable 
• Inventory 
• Prepaid expenses

Current Liabilities

The current liabilities represent any business obligation that is payable within less than one year.

Here are a few examples of what current liabilities can include:

• Accounts payable 
• Notes payable
• Accrued expenses
• Deferred revenues 
• Taxes payable
• Wages payable 

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Current Ratio Formula

To calculate a company’s current ratio, you’ll need the current ratio formula which is quite simple.

The current ratio formula is:

• CR = Current Ratio
• CA = Current Assets
• CL = Current Liabilities

The current assets include things like cash, accounts receivables, inventory, and any other asset that can be turned into cash within a year.

The current liabilities include things like short-term debt, accounts payable, wages, taxes payable, and any other debt that is payable within a year.

You can rewrite the current ratio formula as follows:

Current Ratio Interpretation

When you calculate the current ratio, what information does it convey?

In essence, the current ratio is the ratio between a company’s total current assets over its total current liabilities.

If a company has $1 million in current assets and $1 million in current liabilities, the current ratio will equal 1.0.

This means the company has $1 of current assets for every $1 of current liabilities.

Now, if the company’s current ratio is 3.0, it means that it has $3 of current assets for every $1 of current liability.

Investors will start wondering whether the company’s management is efficiently using company assets to generate a return.

The company may want to consider investing its excess current assets into productive projects to generate a better return for the shareholders.

On the flip side, if the company’s current ratio is below 1.0, it means that the company does not have enough assets to cover its current liabilities.

The lower the number, the more the company is exposed to potentially defaulting in its short-term debt.

However, just like with most other financial ratios, it’s important to consider the information given by the current ratio along with other ratios.

Since the current ratio is a snapshot of a specific point in time, you may not have the proper information on the context as to why the current ratio turned out the way it did.

Looking at the current ratio and other ratios, comparing it to the company’s industry average, the current ratio trend over time, and so on, can give you a better insight into the company’s financial health.

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Current Ratio Limitations

The current ratio is a great way to quickly assess a company’s ability to use its short-term assets to pay for its short-term liabilities.

However, the current ratio also has some limitations.

In some cases, a company’s current ratio may drop, leading analysts to believe that the company may have liquidity issues, although that may not be true.

The reverse is also true.

In some cases, the liquidity ratio may appear healthy, but the company may not be as financially well-off.

For instance, if a company has used its cash reserves and a significant portion of its working capital to acquire another company, the current ratio may show a great level of risk although the company has efficiently used its assets.

On the flip side, a company may show a healthy current ratio, but the accounts receivables are aged and difficult to collect, or the company may have excess inventory on hand that it cannot liquidate.

It’s important that you consider the current ratio and other financial measures to get a better perspective on the company’s financial position.

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Current Ratio Example

Let’s look at an example of current ratio to better understand the concept.

Let’s assume a company has the following financial characteristics:

• Cash: $200,000
• Accounts receivable: $1,000,000
• Inventory: $5,000,000
• Short-term loans: $1,000,000
• Accounts payable: $1,500,000

Let’s calculate the current ratio.

First, we calculate the current assets by adding cash, accounts receivable and inventory (we get $6,200,000).

Then, we calculate current liabilities by adding short-term loans and accounts payable (we get $2,500,000).

Now, we divide current assets ($6.2M) by the current liabilities ($2.5M) and we get 2.48.

This means the company has $2.48 of short-term assets to pay for every $1.00 of short-term liability.

Let’s imagine that the industry average for this company has a current ratio of 1.5.

This means that the company has more short-term resources than the industry average, so further investigation is required to see if the company is efficiently investing in profitable projects.

However, if the industry average is 2.5, this company operates within the expected liquidity range.

Current Ratio FAQ

What does current ratio mean?

The current ratio is a measure of a company’s ability to meet its short-term obligations using its short-term assets.

Calculating the ratio allows you to assess a company’s financial health and how it uses its short-term resources to cover its short-term liabilities.

The current ratio is classified as a “liquidity ratio” allowing you to measure a company’s liquidity.

Why use the current ratio?

The current ratio is classified as a liquidity ratio and it is a simple way to quickly assess a company’s ability to meet its short-term obligations.

If the company’s current ratio is within the industry average, then the company is operating efficiently.

However, if the current ratio is too high or too low, you should pursue your investigation to understand the company’s financial position better.

What is a good current ratio?

There is no scientific answer as to what is a good current ratio.

A good current ratio will depend on the company’s industry and the nature of its business.

However, as a rule of thumb, a good liquidity ratio can be anywhere between 1.5 and 3.0.

If your current ratio is too high, it means that you have excess resources that may be idle and not producing a good rate of return.

If your current ratio is too low, it means that you don’t have enough resources to pay for your short-term debt if all of the debt were theoretically payable immediately.

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How do you calculate current ratio?

Calculating the current ratio is quite simple.

To calculate the current ratio, you must take a company’s total current assets and divide it by the company’s total current liabilities.

For example, you add up cash, accounts receivables, inventory, and prepaid expenses and you divide that by the sum of accounts payable, taxes payable, and deferred revenue.

Takeaways 

So there you have it folks!

What is the current ratio?

In a nutshell, the current ratio is a measure of how much short-term resources a company has to meet its short-term obligations.

By calculating the current ratio, you are assessing a company’s liquidity.

You can calculate it by taking the ratio between a company’s current assets and its current liabilities.

Typically, companies try to keep their current ratio within the industry average.

A high current ratio may suggest that the company’s management team may not be utilizing the company’s resources efficiently to generate a higher return to the shareholders.

A low current ratio may suggest that the company is facing liquidity issues as it does not have enough short-term resources to pay for its short-term debt.

Now that you know what the current ratio is, how to calculate it, and what information it provides, good luck with your research!

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