What is Current Ratio
Current ratio is a measure of the short-term liquidity of a company, reflecting the dollars of current assets available to repay short-term debt (current liabilities). The current ratio is a comparison between the current assets which include cash, receivables, and inventory with current liabilities.
The current ratio is the most commonly used to measure the business’s liquidity. Liquidity is a concern of ability of a company to pay its debt in the short run.
The current ratio is computed by dividing the current assets by current liabilities as this following equation.
- Current Ratio = Current Assets ÷ Current Liabilities
To analyze the business’s liquidity, you can compare the company’s current ratio with the industry average, competitor company, or the company’s past period.
Generally, a high current ratio indicates a strong business’s liquidity. In contrast, a low current ratio means a business’s liquidity is weak or worst than the past, or the competitor.
Key Points
- Current ratio expresses the relationship between current assets and current liabilities, reflect the dollars of current assets available to repay short-term debt.
- The current ratio is a comparision between current assets and current liabilities of a company.
- The more current assets ratio, the more liquidity that the business has.
- Too high current ratio might indicate that the business has too much old inventory and accounts receivable.
Current Ratio Calculation
The Current ratio expresses the relationship between current assets and current liabilities. Expresses the relationship of current assets to current liabilities “how many time that the company has current asset to repay its short-term debt”.
The calculation of the current ratio as follow:
Current Ratio = Current assets ÷ Current liabilities
For example, the Feriors company’s balance sheet shows the total current assets of $16 million and the total current liabilities of $1 million. The industry average of current ratio is 10 times.
Solution:
Current ratio = 16 Million ÷ 1 Million = 16 times
The Feriors’ current ratio is 16 times which means the company’s currents assets are 16 times more than its current liabilities. Also, better than the industry average.
Current Ratio Meaning
The current ratio is a ratio that measures the company’s liquidity. Liquidity means the ability of a company to pay its debt in the short run. Once you compute the current ratio, you need to compare the value with the industry average, competitor company (in same industry), or your company’s history.
A higher current ratio indicates a strong liquidity of the company. Likewise, a lower current ratio indicates the worst liquidity of the company. Thus, the higher the liquidity ratios, the less liquidity risk a business has.
However, in some cases, the high current ratio might indicate that the firm has too much cash, receivables, and inventory. This reflects the case that the business is not being managed efficiently.
Too high a current ratio might indicate that the business has too much old inventory and accounts receivable.
- Old inventory – need someone to buy to turn to cash, and may turn to obsolete goods.
- Account receivable – need to wait until you get paid, and might able to be bad debts.
In conclusion, extremely high levels of liquidity can prevent the business against liquidity crisis, but also show bad management and cause lower returns on assets.
