What Is Current Ratio – Its Formula, Calculation, Example and What It Interprets
Liquidity ratios of many types are used to determine the solvency of a company. Current ratio is a type of liquidity ratio that indicates whether a business will be able to pay off its outstanding debts. The better the current ratio, the better the business’s ability to pay off its debts, and the safer it is to invest in.
Many analysts and investors prefer looking into a company’s current ratio because, unlike other liquidity ratios, the current ratio considers both existing assets and current liabilities. This blog is your ultimate guide to understanding the current ratio, its formula and calculation, what it interprets, its limitations and more. Read on!
How Does the Current Ratio Work?
The investment value of a corporation may be gauged by calculating its current ratio. A current ratio below 1 indicates that a corporation does not have enough liquid assets to cover its short-term obligations.
However, if the current ratio is higher than 1, the corporation has sufficient short-term liquidity to pay down its current obligations. If the company’s current balance is triple the value of its liabilities, the current ratio would be 3, indicating that it is in excellent financial shape.
Whether an organization is worth investing in might be aided by looking at its current ratio. Unfortunately, the current balance is not a static metric; thus, it may not be the most significant indicator of which firm is worth investing in. This is because a firm experiencing difficulty now may progress toward a more favorable current ratio.
Current Ratio Formula
Two items from the balance sheet are used to determine the current ratio formula: current assets and current liabilities. Here’s the equation:
Current Ratio = Current Assets / Current Liabilities
1. Current Assets
All assets on a company’s balance sheet that are not long-term investments projected to be turned into cash, used up, or depleted within a year are considered current assets. These assets include inventories, prepaid expenses, marketable securities and accounts receivable.
2. Current Liabilities
A company’s current liabilities are its debts expected to be paid off within the fiscal year. Typical current liabilities include short-term debt, owed dividends, accounts payable, outstanding expenses and income taxes.
How to Calculate the Current Ratio?
A company’s current ratio is determined by dividing its existing assets by its current liabilities. Inventory, accounts receivable and any other asset that the company plans to convert into cash within a year constitute the current assets.
The sum of all outstanding debts, whether long and short-term, as well as tax and salary obligations and accounts receivable, constitute current liabilities.
What is an Ideal Current Ratio?
To determine the ideal current ratio, it is necessary to consider the company’s past successes and its industry. A corporation with a current ratio of less than 1.00 may have short-term liquidity problems.
There is no need for concern if the drop in the current ratio below 1.00 is just transitory, as may be the case if short-term financial resources were used for capacity growth or company scaling.
Sufficient liquidity is indicated by an ideal current ratio of 1.50 or above. Management is not effectively allocating the company’s cash if the current ratio is 1.50 or above over an extended period.
Interpretation of Current Ratios
Suppose a company’s current liabilities are more than its existing assets. In that case, the current ratio is less than 1.00. A current ratio interpretation below 1.00 may raise red flags, but even a financially healthy firm might see temporary drops in that metric due to external factors.
For instance, if the company’s payment and collection cycles follow a normal pattern, the current ratio can be high when the company collects its dues and fall when payments increase.
In other words, a low current ratio at a given moment may signal that a firm would be unable to meet its short-term financial obligations, but this is not always the case.
Furthermore, large businesses, like Walmart, for example, negotiate far more extended payment periods than suppliers typically allow. If a business does not offer credit to its customers, it will reflect on its balance sheet as a large payables balance compared to the receivables balance.
A high current ratio indicates that a business has a short-term asset value higher than its short-term liabilities. But the high current ratio meaning could also be interpreted as the company not making good use of its available assets.
Components of Current Ratio
Current ratio has two components: current assets and current liabilities.
The assets that are easy to convert into cash within a year are a company’s current assets. These are used to fund ongoing operations.
Since the current assets are the lifeblood of any business, analysts and investors keenly observe the movement in the current asset balance to understand whether investing in the business is a good or bad move.
The assets that fall under this category are:
- Accounts receivable
- Cash
- Short-term deposits
- Marketable securities
- Cash equivalents
Current liabilities are a business’s financial obligations due within the next year. These include:
- Dividends declared
- Income taxes
- Accounts payable
Limitations of Using Current Ratio
1. Payment of Credit
Companies that rely on their line of credit to cover overdue bills often have a cash balance that is very close to zero. If the firm has access to a line of credit, it can still meet its obligations on time, even if the current ratio is low. Still, it remains unclear whether the business will ever be able to repay the loan.
2. Inventory or Stock-in-Trade
If management uses questionable accounting techniques to artificially inflate inventory levels by allocating a disproportionate share of costs to stock, this might be a severe issue.
The time it takes to turn stock into cash may also be more than a year. For a business to get paid for its goods and services, the sales cycle must begin with the first presentation of the goods and continue until the debtor has paid in full.
3. Across Industries
Companies’ internal budgets vary significantly from sector to sector. Therefore, it is tough to compare current ratios across industries.
Current Ratio vs Quick Ratio
The quick ratio measures a company’s liquidity by considering assets that can be converted to cash in 90 days or less. The main difference between the current and quick ratios is that the former takes into account assets that typically take longer to sell. At the same time, the latter considers investments that can be turned into cash rapidly.
Final Word
You can learn much about a company’s general financial health from its current ratio. Its limitations, however, necessitate that analysts repeatedly conduct assessments over many periods and compare the outcomes to those obtained using alternative liquidity measures.
FAQs
Ans: To what extent a certain current ratio is desirable is conditional on the company’s line of business and track record. There is sufficient cash on hand when the current ratio is 1.50 or above.
Ans: With a current ratio of 1.5, the company’s existing assets would cover the current liabilities 1.5 times. To illustrate, let’s say that a corporation has Rs.50,000 in cash and Rs.1,00,000 in accounts receivable. Accounts payable of Rs.1,00,000 make up the company’s current liabilities. If existing assets (Rs.1,50,000) are divided by current liabilities (Rs.1,00,000), the company’s current ratio is 1.5.
Ans: Take the percentage of the company’s current assets to its current liabilities. A company must have accumulated sufficient liquid assets within a year to cover its present liabilities.
Cash, inventories, and receivables are all examples of current assets. Accounts payable, salaries due, and the accrued interest or principal component of a loan are all examples of existing obligations.
Ans: The current ratio indicates a company’s financial health by accounting for its ability to pay off its debts and dues. Current ratios tend to be lower in industries that provide steady income, such as consumer products, and higher in sectors that are more susceptible to economic cycles, like construction. Current ratios might vary between organizations in the same industry.
Ans: Since current ratios presume that all inventory and assets can be instantly converted to cash, they may not always provide an accurate picture of a company’s liquidity. However, during economic downturns, this may not hold. Calculating immediate liquidity requires deducting inventory from asset totals, which is why acid-test ratios are used in these circumstances.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
