Current Ratio – Meaning, Formula, Calculation with Examples, Pros and Cons

Numerous accounting measures, ratios, and formulas can help determine a company’s solvency, liquidity, and profitability. These metrics can also help have a holistic view of a company’s current assets and liabilities. 

The current ratio measures a company’s current assets against its current liabilities. Here’s everything to know more about current ratios, how to calculate them, and how they are useful in determining a company’s financial health.

What is the current ratio?

The current ratio is a ratio used to ascertain a company’s short-term liquidity.

The current ratio assesses a company’s capacity to settle short-term debt or obligations due within a year. Also known as the working capital ratio, this ratio can help analysts and investors to apprehend a company’s ability to utilise its current assets to pay off its existing debt or fulfil other obligations.

A current ratio higher than the industry’s average can be deemed satisfactory. Any ratio lower than the industry average may signify a risk of default. 

• The current ratio is a liquidity ratio that evaluates a company’s capacity to pay off short-term debt.
• Creditors, analysts, and investors use the current ratio to analyse if a company can meet its short-term obligations or debt.
• A current ratio greater than the industry average is considered satisfactory. Any ratio less than the industry ratio indicates a high risk of default.

Importance of current ratio

• The current ratio is used by creditors, analysts and investors to determine if a company can fulfil its short-term obligations.
• It allows analysts to understand a company’s financial standing in terms of assets and liabilities.
• It provides information on the short-term liquidity of a company. 
• This ratio, in combination with other liquidity ratios, can indicate the true standing of a company.

Current ratio formula

The current ratio formula is mentioned below:

Current ratio = Current assets / Current liabilities

Typically, current assets include cash and cash equivalent, cash at the bank, stock, accounts receivable, inventory, and other assets that can be converted into cash or liquidated within 12 months. On the other hand, current liabilities include accounts payable, bank overdrafts, short-term debt and any other liabilities due for the year. 

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Interpretation of current ratio

The current ratio indicates the following:

• If current assets exceed current liabilities, i.e., the ratio is higher than 1.0, it indicates the ability of a corporation to meet its obligations. It may also imply that the company is optimally using its current assets or managing its working capital satisfactorily.
• If current assets are less than current liabilities, i.e. the ratio is less than 1.0, it can indicate that the company does not have enough cash or liquidity to meet its short-term obligations and debts.
• If current assets equal current liabilities, i.e. the ratio equals 1.0, then it implies that the company can cover its obligations for the concerned year/period. 

Drawbacks to the current ratio

• The current ratio does not account for long-term liabilities or assets of different nature. As a result, this ratio cannot give an accurate picture of a company’s total assets or liabilities.
• The current ratio individually may not suffice to determine a company’s liquidity. This is because it is based on the quantity of assets and doesn’t consider quality.
• Often inventory is also considered while calculating the current ratio. In some circumstances, this might lead to overestimating a company’s liquidity. This is because certain companies may have high inventory due to low sales. In such cases, this ratio can then lead to incorrect computation.
• The current ratio poses a problem for companies with seasonal revenues. It may indicate a lower ratio in some months and higher in others.
• Sometimes a company might change its inventory valuation, impacting the current ratio.

How to calculate the current ratio from the balance sheet?

On the balance sheet, you will readily find current assets and liabilities recorded and accounted for separately. You can pick the values and insert them into the formula to calculate the current ratio.

Also, some companies present liabilities, profitability and other ratios in their annual and quarterly reports. You can refer to them to understand the current ratio of the concerned company. 

Current ratio example calculation

Let us understand the current ratio with an example. 

For instance, assume Company A has the following current assets:

• Cash = Rs. 20 lakh
• Inventory = Rs. 22 lakh
• Marketable securities = Rs. 15 lakh 

Current liabilities of the same company are as mentioned below:

• Short-term debt = Rs. 30 lakh
• Accounts payable = Rs. 10 lakh

The total current assets and liabilities would be as follows:

• Total current assets= 20+22+15 =Rs. 57 lakh
• Total current liabilities= 30+10 = Rs. 40 lakh

So, according to the formula:

Current ratio= Rs. 57 lakh / Rs. 40 lakh = 1.455

Company A has a current ratio of ~1.4. This suggests that it can readily settle its short-term obligations or liabilities.  

Conclusion

Companies can utilise the current ratio to assess their short-term liquidity. The current ratio assesses a company’s ability to satisfy its current obligations, which are normally due within a year. The higher the assets, the higher the current ratio. It is ideal for companies to have a current ratio of more than 1. However, this ratio should be considered along with a set of other financial ratios and statements to fully assess a company’s standing. 

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