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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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