The current ratio is one of the important indicators when it comes to determining a company’s solvency - the ability to pay its short-term obligation using its current assets. The accounting ratios reflect the overall financial health of a company. Here’s how it works and how you can calculate it.
What is the current ratio?
The current ratio (also known as the current asset ratio, the current liquidity ratio, or the working capital ratio) is a financial analysis tool used to measure the capability of a business to meet its short-term obligations that are due within a year.
The ratio considers the weight of all of your company’s current assets with your short-term liabilities and tells you whether you have enough of the former to pay for the latter. In other words, this lets you the financial health of your company and how can maximize the liquidity of the current assets to settle debt and payables.
How the current ratio works
The current ratio (CR) is one of the first things that accountants and investors will look at when assessing the health of your business, then determine whether it’s a good investment.
A company with a current ratio of less than 1 means it has insufficient capital to pay off its short-term debt because it has a larger proportion of liabilities relative to the value of its current assets.
On the other hand, if it is greater than 1, the company will likely pay off its current liabilities since it has no short-term liquidity concerns. An excessively high CR , above 3, could mean that the company can pay its short-term debts three times. It could also be a sign of ineffectiveness in managing a company's funds.
It can help determine whether a company would be a good investment. However, this ratio changes over time, and it may not the best determining factor. In fact, investors combine and analyze different factors before making investment decisions.
What is the current ratio formula?
This is a comparison of current assets to current liabilities, calculated by dividing two common variables found on a company's balance sheet: current assets and current liabilities. Potential investors and creditors use this to measure a company's liquidity or ability to pay off short-term debts.
Current Ratio = Current Assets/Current Liabilities |
Current Assets
Current assets are all assets listed on a company's balance sheet that are expected to be conveniently sold, consumed, used, or exhausted through standard business operations within one year. Current assets, also known as current accounts would include cash, cash equivalents, accounts receivable, stock inventory, marketable securities, pre-paid liabilities, and other liquid assets.
Current Liabilities
Current liabilities are a company's short-term obligations that are due within one year or within a normal business cycle. Common current liabilities appear on the balance sheet, including short-term debt, accounts payable, dividends owed, accrued expenses, income taxes outstanding, and notes payable.
Example of Current Ratio
For example, if your business holds $200,000 in current assets and $100,000 in current liabilities, your business currently has a current ratio of 2. This means that you can easily settle each dollar on a loan or accounts payable twice.
Current Ratio = $200,000/$100,000 = 2 |
If we swap these and say that you have $100,000 in current assets and $200,000 in current liabilities, the current ratio is 0.5 now. This means that you’d be able to pay off about half of your current liabilities if all current assets were liquidated.
Current Ratio = $100,000/$200,000 = 0.5 |
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