Current ratio

Page written by AI. Reviewed internally on June 26, 2024.

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.

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