Current Ratio is a measure of a company’s short-term financial health. It indicates how effectively a company can use its current assets to pay down its current liabilities. If a company has a high current ratio, then it is understood that the firm is in a good position of liquidity. A low current ratio could also suggest they don’t have enough money to pay bills soon. Here in this article, we can discuss the meaning of current ratio, formula of current ratio, its limitations and even see one current ratio example to understand it in a better way.
What is Current Ratio?
Current ratio is a financial tool that is as simple as it is powerful. It illustrates how a business can cover short-term obligations with short-term assets. Current assets are cash, accounts receivable, and inventory. Short-term obligations are accounts payable and short-term loans available.
Concept of Current Assets and Liabilities
- Current Assets : Assets such as cash, accounts receivable, inventory, short-term investments, and other current assets expected to be converted to cash in less than one year.
- Current Liabilities: AP, ST loans, salaries payable, taxes payable, etc which are due within one year.
A current ratio of less than one is a sign of potential liquidity problems. For instance, the standard current ratio is 2:1. It reflects that the company has twice as many assets as liabilities. Some industries will have different acceptable ratios, of course.
| Items | Examples |
| Current Assets | Cash, Inventory, Receivables |
| Current Liabilities | Payables, Borrowed Money |
How to Calculate Current Ratio?
If you have access to the company’s balance sheet, calculating the current ratio is very simple. All you need are two numbers: total current assets and total current liabilities.
Steps to Calculate:
Step 1: Determine total current assets.
Step 2: Calculate the total current liabilities.
Step 3: Next, we will apply the simple current ratio formula:
Current Ratio Formula:
| RatioFormula | |
| Current Ration: Current Assets / Current Liabilities |
Example Calculation:
Suppose a company has:
- Current Assets = ₹150,000
- Current Liabilities = ₹75,000
- Current Ratio = ₹150,000 / ₹75,000 = 2.0
That is, the company has ₹2 in assets for every ₹1 it owes. Use a current ratio calculator for faster results.
What is Good Current Ratio?
A good current ratio depends on the industry in which a company operates. However:
- Standard Current Ratio is 2:1
- The consensus is that a ratio of 1.5 to 2 is generally safe.
- A current ratio under 1 may indicate liquidity problems.
Interpretation:
- Greater than 2: This company is rich with liquidity, but it might not be using its assets efficiently.
- About 2: The company is healthy and balanced.
- Less than 1: The company may have trouble meeting its short-term obligations.
What are the Limitations of the Current Ratio?
While the current ratio is a valuable tool for assessing liquidity, it has some limitations that need to be considered when interpreting the results.
- Quality of Assets: The current ratio considers all the assets to be created equal. But not all current assets can be converted to cash so readily. For instance, it can be slow to sell inventory.
- Timing of Liabilities: The ratio does not take into consideration when liabilities are due. One company can have a high current ratio but be running out of cash if large payments are due shortly.
- Industry Differences: There are norms in every industry. What works well for a retail business may not be the best for a manufacturing business.
| Industry | Ideal Current |
| Retail | 1.1 to 1.5 |
| Manufacturing | 2.0 to 3.0 |
- Overemphasis on Short-Term: This only looks at the short term and doesn’t really tell you much about the company’s financial strength in the long run.
Current Ratio Calculation Example
For better understanding, let us take real examples of current ratio.
Example: ABC Ltd.
The balance sheet of ABC Ltd. would be as follows:
Current Assets:
- Cash: ₹50,000
- Amount Due From (Debtor): ₹100,000
- Inventory: ₹75,000
Current Liabilities:
- Accounts Payable: ₹80,000
- Short-term Loan: ₹20,000
Step-by-Step Calculation
- Total Current Assets = ₹50,000 + ₹1,00,000 + ₹75,000 = ₹225,000
- Sum of All Current Liabilities = ₹80,000 + ₹20,000 = ₹100,000
- Current Ratio = ₹225,000 / ₹100,000 = 2.25
Interpretation: ABC Ltd is well liquid. For every ₹1 of liability, they have ₹2.25 worth of assets. This means that they can comfortably pay their short-term debts.
Current Ratio FAQs
1. What is a good current ratio?
A strong current ratio is between 1.5 and 2.5, showing that a company can more than cover its short-term liabilities. It shows strong liquidity without too much cash going to waste.
2. What does a current ratio of 2.5 indicate?
A current ratio of 2.5 means the company has ₹2.5 of current assets for every ₹1 of current liabilities, indicating very strong liquidity, though possibly under used resources.
3. Is 1.0 a good current ratio?
With a current ratio of 1.0, a company has just enough assets to cover liabilities, but it provides no cushion for unexpected operating needs, and it is considered risky.
4. Why is 1.5 a good current ratio?
A current ratio of 1.5 indicates a good financial position, where assets comfortably cover liabilities, striking a good balance between safety and efficient utilization of resources.
5. Is 2.0 a good current ratio?
Yes, a 2.0 current ratio is very good, to the extent that it means the company can pay its obligations twice over, demonstrating financial strength and stability.
