What Is The Current Ratio?
The current ratio is a type of liquidity ratio that measures a company’s capability to repay its current liabilities. it is also known as a working capital ratio. The current ratio indicates the financial health of the company.
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Formula And Calculation of Current Ratio
To calculate the current ratio analysts have to compare a company’s current assets and current liabilities. To get the current ratio you have to divide the current assets by the current liabilities.
Current Ratio = Current Assets/Current Liabilities
You can find the current assets and current liabilities of a company from their balance sheet.
Current assets represent the value of all assets that can easily convert into cash within a period of one year. Here are a few examples of current assets:
- Cash and cash equivalents
- Marketable securities
- Accounts receivable
Current liabilities are all the short-term debt of a company, that the company has to pay within a year. Here are a few examples of current liabilities:
- Short-term debt
- Current portion of long-term debt
- Accounts payable
- Interests payable
Suppose a company’s current assets value is $800 million and its current liabilities stand at $400 million, then what will be the company’s current ratio?
Current Ratio = Current Assets/Current Liabilities = $800 million/$400 million = 2.0
A 2.0 current ratio means the company has as much as twice the amount of current assets to cover its liabilities and the company has enough liquidity.
Preferred Current Ratio
The preferred current ratio is generally between 1.5 to 3 and considered healthy. But, the current ratio depends upon the type of industry. If a company has a lower current ratio then its peer industry, it has a higher chance of default and considered risky to invest in. A company with a current ratio of more than 3 means the company has very high unused cash and the management is not looking for its growth opportunity.
Importance of Current Ratio
- The current ratio helps to understand, how much cash a company has. It helps us measures the short-term financial strength of a business. With a higher ratio, the company is more stable and with a lower ratio, the company has a greater risk of liquidity.
- The current ratio also gives a good idea of a company’s overall operations. It helps to understand, how efficient the company is in selling products and convert its inventory into cash and how quickly it is doing it. It also helps the company to optimize its production and in this way, the company also optimizes the overhead costs.
- The current ratio also shows the management’s efficiency and how they fare in meeting the creditor’s demands. It also gives an understanding, how the working capital of the company is being used.
Limitations of Current Ratio
- Using the current ratio on a standalone basis is not sufficient to analyze the liquidity position of the business as the ratio relies more on the number of current assets, then of the quality of the assets.
- Another limitation of the current ratio is that it is not fair to compare companies from different industries as the requirement of working capital changes with industry.
- In the case of seasonal companies, where most of its sales are seasonal; you may see fluctuation in the current ratio.
- The Ratio can also be changed due to the change in the inventory valuation method of the company. Such a situation will not be a case while using the other liquidity ratio like a quick ratio since it does not consider the company’s inventory.
- A similar increase or decrease in the current assets and liabilities can change the current ratio. Hence, drawing more money against the inventory can manipulate the current ratio, that too easily.
The current ratio is a very good fundamental indicator, with certain limitations. What makes it good or bad often changes with its interpretation.