Current Ratio

Current Ratio

The current ratio is a liquidity ratio that measures the company’s ability to meet its current liabilities in full. It is calculated by dividing current assets by current liabilities.

Formula:Current Ratio = Current Assets / Current Liabilities

Interpretation:

• A current ratio of 1 indicates that the company is able to meet its current liabilities in full and has a perfect current liquidity position.
• A current ratio greater than 1 indicates that the company has excess current assets, which can be used to cover current liabilities.
• A current ratio less than 1 indicates that the company has insufficient current assets to cover its current liabilities.

Components of Current Ratio:

• Current Assets: Cash, accounts receivable, inventory, prepaid expenses, and other current assets.
• Current Liabilities: Accounts payable, short-term debt, current portion of long-term debt, and other current liabilities.

Uses:

• To measure the company’s liquidity and ability to meet current obligations.
• To assess the company’s ability to manage its current liabilities effectively.
• To compare companies’ liquidity performance.

Limitations:

• Does not consider the company’s size or industry.
• Can be misleading if the company has a large inventory or a high proportion of current liabilities.
• Does not provide information about the company’s long-term solvency.

Example:

A company has current assets of $100,000 and current liabilities of $60,000. Its current ratio is:

Current Ratio = $100,000 / $60,000 = 1.66

This indicates that the company has excess current assets and is able to meet its current liabilities in full.