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.
FAQs
What does a current ratio of 1.0 mean?
A current ratio of 1.0 means that a company has exactly enough current assets to cover its current liabilities. It indicates that for every dollar of liabilities, there is one dollar of assets.
Is a current ratio of 1.0 good?
A current ratio of 1.0 is generally considered acceptable but not ideal. It means the company can cover its debts, but there is no extra margin for unexpected expenses.
What is a good current ratio?
A good current ratio typically ranges between 1.5 and 2.0, indicating that a company has enough assets to cover its liabilities with some cushion for unexpected events.
How is the current ratio calculated?
The current ratio is calculated by dividing a companyโs current assets by its current liabilities: Current Ratio = Current Assets / Current Liabilities.
