Current ratio

Definition

The current ratio is a financial metric used to assess a company’s short-term liquidity and its ability to cover immediate financial obligations with its current assets. 

What is a current ratio?

The current ratio, along with other financial ratios, is typically disclosed in a company’s financial statements, providing transparency to stakeholders about its short-term liquidity position.

The current ratio is calculated using the following formula:

Current ratio = total current assets / total current liabilities

A current ratio greater than 1 indicates that a company has more current assets than current liabilities, while a current ratio of less than 1 implies that a company may have difficulty meeting its short-term obligations using its current assets alone. A higher current ratio indicates a healthier level of working capital.

The ‘ideal’ ratio is between 1.5 and 2. The current ratio provides a snapshot of a company’s short-term liquidity, but it doesn’t offer insight into the company’s ability to generate cash in the future.

Example of current ratio

Let’s consider an example for a fictional company, XYZ Inc.:

Current assets:

• XYZ Inc. has €200,000 in cash and cash equivalents.
• Accounts receivable amount to €150,000.
• The inventory is valued at €100,000.
• Prepaid expenses stand at €20,000.

Total current assets = €200,000 + €150,000 + €100,000 + €20,000 = €470,000

Current liabilities:

• Accounts payable total €80,000.
• Short-term loans amount to €50,000.
• Accrued liabilities are €30,000.
• The short-term portion of long-term debt is €40,000.
• Income taxes payable are €10,000.

Total current liabilities = €80,000 + €50,000 + €30,000 + €40,000 + €10,000 = €210,000

Now, using the formula for the current ratio:

Current ratio = €470,000 / €210,000 = 2.24

In this example, XYZ Inc. has a current ratio of approximately 2.24. This means that for every dollar of current liabilities, the company has €2.24 in current assets.