Current Ratio: Meaning, Formula & Importance in Financial Analysis

The Current Ratio is that critical financial metric in determining how effective a business will be in meeting its short-term liabilities out of the short-term assets it has. The ratio reveals how liquid a business is and if it can meet its immediate obligations without having to liquidate long-term assets or seek further finances. A high current ratio typically indicates a healthy company. It may be said that a low ratio may lead to liquidity or working capital problems.

In this article, we will explore the meaning of the current ratio, its calculation, formula, limitations, and an example to understand how it is used in financial analysis.

What is the Current Ratio?

Current ratio is a benchmark of comparison which measures the ratio between the current assets and the current liabilities of a firm. Therefore, it simply measures how easily a company can liquidate its working assets such as cash, inventory, and receivables to pay its operating liabilities such as accounts payable and short-term loans that fall due within one year.

• Current Assets: These include assets that are expected to be converted into cash within a year, such as cash, accounts receivable, and inventory.
• Current Liabilities: These are liabilities that need to be paid off within the same period, such as accounts payable, short-term loans, and other obligations due within the year.

The current ratio is stated as a number, typically greater than one. In general, above 1.5 or 2, all is healthy; it suggests that the firm can pay its obligations when they come due, not just barely be able to do so. Depending on the industry, even stricter standards may apply.

How to Calculate Current Ratio?

To calculate the Current Ratio, you need to gather the total value of current assets and current liabilities from the company’s balance sheet. The formula is simple:

Current Ratio Formula:

Current Ratio = Current Assets / Current Liabilities

Steps to Calculate

• Identify Current Assets: These are typically listed at the top of the company’s balance sheet. Add up all short-term assets, including cash, marketable securities, receivables, and inventory.
• Identify Current Liabilities: Listed below current assets on the balance sheet, these include short-term debts, accounts payable, and other obligations due within a year.
• Apply the Formula: Divide the total current assets by total current liabilities to determine the ratio.

Current Ratio Formula

The Current Ratio Formula is straightforward and can be applied by anyone reviewing a company’s financial statements.

Formula Recap:

Current Ratio = Current Assets / Current Liabilities

This ratio measures liquidity, providing insight into a company’s ability to handle its short-term financial commitments. A ratio greater than 1 indicates that the company has more assets than liabilities, while a ratio less than 1 signals potential liquidity challenges, as the company may struggle to meet its immediate 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.

• Does not take into account the quality of assets: The current ratio encompasses all the current assets, but not all assets have equal liquidity. For instance, inventory may take considerable time to sell; however, accounts receivable might be collectible in months.
• Ignore Timing of Liabilities: The current ratio does not have regard to when the liabilities are due. It might be correct that a company has a high current ratio but high payables that are nearing their due date.
• Industry Variation: A “healthy” current ratio will vary very significantly by industry. For example, industries with quick turns of inventory, such as retailing, will generally produce a considerably lower ratio than those involving assets which remain relatively tied up for longer periods, such as manufacturing.
• Overemphasis on Short-Term: The measure is too much focused on short-term assets and liabilities, thus neglecting everything that should be related with the long-run capitalization condition of the company and its strategy.

Therefore, it’s essential to use the current ratio in conjunction with other financial ratios, such as the quick ratio or debt-to-equity ratio, to gain a comprehensive understanding of a company’s financial position.

Current Ratio Calculation Example

Let’s go through a practical example to illustrate how the current ratio is calculated and interpreted.

Example:

ABC Ltd. has the following items on its balance sheet:

Current Assets: 

Cash: ₹50,000

Accounts Receivable: ₹100,000

Inventory: ₹75,000

Current Liabilities: 

Accounts Payable: ₹80,000

Short-term Loan: ₹20,000

Calculation

Current Assets: ₹50,000 (Cash) + ₹100,000 (Receivables) + ₹75,000 (Inventory) = ₹225,000

Current Liabilities: ₹80,000 (Payable) + ₹20,000 (Loan) = ₹100,000

Current Ratio: ₹225,000 / ₹100,000 = 2.25

Interpretation

ABC Ltd. has a current ratio of 2.25, meaning that for every ₹1 of liability, the company has ₹2.25 in current assets. This suggests that ABC Ltd. is in a strong liquidity position and should be able to meet its short-term obligations comfortably.

Conclusion

Current Ratio is one of those tools that is most important for a good assessment of short-term liquidity as it calculates the liquid assets of a firm against its liquid liabilities. The higher ratio means better liquidity; however, asset quality and the industry’s standards should be paid attention to. Even though it is useful as a metric, the current ratio, in its own limitations, needs to be considered with other financial metrics to give a complete view of business stability.

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Current Ratio FAQs

What should be the current ratio of a business?

Traditionally, the ideal current ratio would be usually between 1.5 and 2, meaning that there is a good balance between assets and liabilities. Of course, it would depend on the industry.

How would you calculate the current ratio?

This is calculated as by dividing the current assets to current liabilities through the formula

Current Ratio = Current Assets / Current Liabilities

What are the drawbacks of the current ratio?

Limitations include that it cannot measure asset quality, liability timing, and industry-specific variation, and because its focus is on short-term financials.

What does a current ratio of less than 1 mean?

A ratio less than 1 indicates that liabilities have exceeded the assets of the company, and that there may be signs of liquidity problems.

Can the current ratio become too large?

Yes, A too high current ratio may imply an inefficient usage of assets or that the company is sitting on cash instead of using it through profitable growth opportunities.