Current Ratio: Definition, Formula, Example

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While analysing a company, it is critical to understand how much liquidity it possesses. The current ratio is one such widely used liquidity ratio that helps determine a company’s financial health. It typically helps to know if the business has adequate liquidity to meet its near-term debt obligations. What is a current ratio? This article delves into everything you need to know about the current ratio meaning and how it differs from the quick ratio.

What Is the Current Ratio?

A current ratio, also called the working capital ratio, measures a company’s capacity to meet its short-term debt commitments within the next year. The ratio considers the weight of a company’s current assets versus its near-term liabilities.

Current assets are the ones that can be converted into cash within the next 12 months. For example, bank fixed deposits, accounts receivable from debtors, mutual fund investments, cash and marketable securities, inventory, etc. Additionally, current liabilities are the debt obligations due within the next year. Examples include short-term loans from creditors, cash credit/overdraft, loan instalments, advances from customers, etc.

Additional Read: What is PE Ratio?

Formula and Calculation for the Current Ratio

Let us understand how to calculate the ratio using the current ratio formula.

Current ratio = Current assets / Current Liabilities

Let us understand the calculations with the help of an example.

Current AssetsAmount (Rs.)Current LiabilitiesAmount (Rs.)
Cash and cash equivalents15,000Short-term debt15,000
Marketable securities25,000Accounts Payables15,000
Inventory20,000  

The total value of current assets = Rs. 15,000 + 25,000 + 20,000 = Rs. 60,000

Similarly, total liabilities = Rs. 15,000 + 15,000 = Rs. 30,000

Current ratio = Rs. 60,000/Rs. 30,000 = 2.0x

The business has a current ratio of 2x, which implies that it has twice the liquidity to fund its short-term debt obligations.

How the Current Ratio Changes Over Time

The current ratio of a company might keep changing with time. A steady rise in the current ratio might indicate that the business has been improving its liquidity and financial health. On the other hand, a declining ratio might indicate the financial stability of a company has been gradually declining.

Let us understand what the different values of the current ratio mean for a business (where CR denotes the current ratio)

Current RatioSignificance
CR > 1Current assets are more than short-term liabilities – a favourable situation for the business.
CR = 1Current assets are equal to current liabilities. It denotes that the business has enough assets to meet its short-term debt commitments.
CR < 1The company’s current assets are less than its near-term debt commitments. It is a situation where the company may not have sufficient funds to repay its near-term debt obligations.

So, what is ideal current ratio? A higher current ratio might be a good indicator while evaluating a company. However, a very high current ratio value might indicate that the company cannot manage its capital efficiently to produce profits. An ideal current ratio is primarily dependent on the nature of the business. However, a ratio between 1.5 to 2 might be considered an ideal current ratio across companies. It implies the company has more financial resources to cover its near-term debt obligations. 

Current Ratio Vs. Quick Ratio

A quick ratio also called the acid-test ratio, determines the capacity of a company to meet its short-term debt obligations by quickly converting its assets into cash. Unlike the current ratio, the quick ratio does not consider some specific current asset entries such as prepaid expenses and inventory. It is because prepaid expenses cannot be used to fund current liabilities, and inventories may take longer to convert into cash.

You can calculate the quick ratio using the below formula.

Quick Ratio = [Cash and Cash Equivalents + marketable securities + accounts receivables] / Current Liabilities

Alternatively, you can also calculate the quick ratio using this formula.

Quick Ratio = [Current Assets – Inventory – Prepaid Expenses] / Current Liabilities

A quick ratio of greater than one indicates the company is doing well and vice versa. Many financial analysts believe the quick ratio gives a more accurate representation of a company’s financial soundness than the current ratio.

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