Current Ratio definition

By definition current ratio is a ratio of current assets to current liabilities. It is calculated to assess the liquidity of a business and also to assess the businesses ability to repay its current obligation using its current resources.

How to calculate current ratio?

What is a good current ratio?

The current ratio is a comparative ratio and it can be either higher or lower than a suitable base. Generally, it is perceived that the current ratio should be at least 1:1. But that is not the all-time case. Some businesses operate in such sectors where high liquidity is preferred due to high uncertainty of operations. On the other side, there are some industries where higher liquidity is not the utmost priority of the business as operations are predictable. In both cases an industry average current ratio is desirable. However, if the asset management objectives of a business are prime then a minimum or maximum limit of this ratio can be defined.  

Current ratio vs Quick ratio

The current ratio is calculated by dividing all current assets with all current liabilities. The current assets include all balance sheet items under current assets including cash and cash equivalents, inventories, receivables, short-term investments, prepaid expenses and other current assets.

Whereas, quick ratio is calculated as an additional measure to current ratio, without the impact of inventories, in order to assess the quick availability of liquid resources. It is also called acid test ratio and is calculated as:

                                                   

Current ratio Example

Suppose you are running a business that has current assets and current liabilities as follows:

                                   

Current ratio interpretation

Again it depends on what the management goals are or what the industry average is. One interpretation of current ratio is that it tells us the liquidity position of the company in terms of availability of current assets to settle off its current liabilities. Another interpretation is that it let us know the level of networking capital tied up in the operations of a business. If the current ratio is closer to industry average then it is normally safe, but for some companies, a higher current ratio is desirable where there is the high uncertainty of operations. Generally, it should be at least 1:1.

Is a high current ratio good?

If a business is holding too many current assets as compared to its current liabilities, resulting in a higher current ratio that does not mean it’s a good sign.  If the industry average ratio is 1.5:1 and business has a current ratio of 4:1 then it can be interpreted that the company has invested excess cash in its operations. This could result in a problem of overtrading and it could be difficult in some circumstances to withdraw resources and that is dangerous sometimes.



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