Current Ratio – Meaning, Formula and How it works?

As a stock market investor, you may have frequently come across the terms such as liquidity ratio, current ratio, and working capital ratio. Well, these are key financial ratios used by investors and analysts to analyze companies.

In this article let’s take a detailed look at:

What is Current Ratio?

Current Ratio Definition: A Simple Overview

The current ratio refers to a liquidity ratio that measures a business’s ability to pay short-range obligations or those payable within one year. The current-ratio is a very important ratio that helps investors and analysts to understand how a company can maximize the current assets in its balance sheet to pay off its current debt and other payment liabilities.

Current Ratio Meaning: How It Measures Liquidity and Solvency

According to experts, while a current-ratio that is similar to the industry average or a tad higher is generally considered acceptable, a current ratio lower than the industry average shows a high risk of default. Further, if a company has a very high current-ratio in comparison with similar companies in the industry where it operates, it is an indicator that management may not be efficiently using its assets. The current ratio is referred to as “current” as it includes all current liabilities and current assets.

How to calculate Current Ratio?

To calculate the Current-Ratio, one should compare the company’s current assets with its current liabilities. If you are wondering where to find all this information, don’t worry as everything is listed in the company’s balance sheet which can be found on a company’s website.

Current assets of a company include cash, prepaid expenses, accounts receivable, inventory, marketable securities, and other current assets (OCA) that are likely to be liquidated in short term (over a period of one year). Current liabilities include accounts payable, accrued liabilities, wages, any other liabilities payable in short term (over one year period), short-term debts, and taxes payable.

Current Ratio Formula: How It Works and Why the Current Ratio is a Key Indicator of Financial Health

1. Current Ratio Formula: Current Assets / Current Liabilities

The formula to calculate the current ratio is straightforward:

Current Ratio = Current Assets / Current Liabilities

2. Explanation of Current Assets and Current Liabilities

• Current Assets: Include cash, accounts receivable, inventory, marketable securities, and prepaid expenses—all assets that can be liquidated within a year.
• Current Liabilities: Comprise accounts payable, short-term loans, accrued expenses, and other liabilities due within a year.

3. Example of How to Calculate Current Ratio

Let’s say XYZ Company has the following financial data:

• Current Assets: ₹5 crore
• Current Liabilities: ₹4 crore

Using the formula: Current Ratio = ₹5 crore / ₹4 crore = 1.25

This means XYZ Company has ₹1.25 in current assets for every ₹1 in current liabilities, indicating a reasonably healthy liquidity position.

What is an Ideal Current Ratio?

1. Industry Benchmarks for Current Ratio

The ideal current ratio can vary by industry due to differences in operating cycles and capital structures. For instance:

• Retail: Typically higher due to substantial inventory levels.
• Technology: May have a lower ratio, reflecting efficient cash use.

2. Understanding a Good Current Ratio (1.5 to 2.0) and Its Implications

An ideal current ratio generally falls between 1.5 and 2.0, indicating the company has sufficient liquidity without overstocking cash or inventory. A ratio below 1.0 suggests liquidity concerns, while one above 2.0 may indicate inefficient asset use.

3. When a High or Low Current Ratio Indicates Financial Risk

• High Ratio: May signify underutilized assets or poor asset management.

Low Ratio: Indicates potential difficulty in meeting short-term liabilities, raising concerns about solvency.

How to Calculate Current Ratio Step-by-Step

1. Identifying Current Assets and Liabilities on a Balance Sheet

Locate “Current Assets” and “Current Liabilities” on the company’s balance sheet. These figures are usually listed in the financial statements.

2. Plugging Values Into the Formula

Divide the total current assets by current liabilities using the formula: Current Ratio = Current Assets / Current Liabilities

3. Using a Current Ratio Calculator for Quick Results

Many online tools, like a current ratio calculator, allow you to input the values directly for quick and accurate results. These tools simplify the process and save time for investors.

Importance of Current Ratio in Financial Decision-Making

1. Assessing Liquidity to Meet Short-Term Obligations

The current ratio helps businesses ensure they can meet short-term liabilities without facing liquidity issues, offering a snapshot of financial stability.

2. Comparing a Company’s Financial Position to Industry Standards

By benchmarking against industry averages, the current ratio allows stakeholders to evaluate whether a company is outperforming or lagging behind its peers.

3. Role of Current Ratio in Securing Loans or Investments

Lenders and investors often review the current ratio to assess a company’s creditworthiness and liquidity before approving loans or investments.

Common Mistakes When Interpreting Current Ratio

1. Ignoring Industry-Specific Variations in Ideal Ratios

Different industries have varying operating cycles, which can impact the ideal current ratio. Failing to account for this can lead to misinterpretation.

2. Misinterpreting Results Without Context

A current ratio alone doesn’t provide the full picture. It must be analyzed alongside other metrics like quick ratio and debt-to-equity ratio.

3. Focusing Solely on Current Ratio Without Considering Other Metrics

Over-reliance on the current ratio without examining cash flow, profitability, or long-term debt can lead to incomplete financial assessments.

Conclusion

Theoretically, a high Current Ratio, implies that a company is capable of paying its short-term obligations because it has a larger proportion of short-term asset value as compared to its short-term liabilities. However, a consistently high Current-Ratio, means that the company has adequate financial resources to remain solvent in the short term, it may also mean that the management of the company is not efficiently using its current assets.

While analysing a company for smart investment, one should always look at the Current Ratio in conjunction with other important ratios. Invest wisely after detailed research.

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