What is current ratio?
Current ratio compares a company’s current assets to its current liabilities, essentially measuring a company’s ability to fulfil short-term financial obligations. It’s a good indicator of financial health and can warn of impending issues if the ratio is too low or even too high.
A company’s current ratio should be roughly in line with industry averages, as a ratio that’s too high could indicate that assets are being used inefficiently, while a low ratio could mean financial or management problems.
Key takeaways from this section:
- Current ratio compares a business’s current assets with its current liabilities and shows its ability to pay short-term debts.
- When using current ratio to assess a company’s financial health, it should be taken in context with past performance and other similar companies in the same industry.
- Current ratio only provides a surface-level look at the financial health of a company, and further analysis is needed to understand the nature of current assets and how easily liquidated they are.
Understanding the Current Ratio
The core purpose of a current ratio is to measure a company’s ability to fulfil short-term liabilities such as debts and supplier invoices using its current assets, meaning cashflow or stock inventory. A ratio of less than 1.0 can mean a company will struggle to meet its financial obligations for the current period, while a ratio higher than 1.0 shows a company has the financial stability and is able to pay current debts and invoices.
The use of current ratio should be deployed in conjunction with other measures for a more complete financial picture, as current ratio only provides a limited view. A company’s ratio may be low because of investment projects or because customers are being slow to fulfil invoices. Likewise, the ratio could appear high and healthy, but the business’s ability to shift stock might be hampered by other factors, meaning there may be problems on the horizon.
The current ratio can be best utilised as a comparison with competitors and historical norms for a company, so a business can see if the ratio is normal for their industry or for a certain time of year.
Current Ratio in practice
It can be hard to say what a good or bad current ratio really looks like, as it only shows a small snapshot of a business’s financial activity. Looking at multiple current ratios over a longer period can be much more insightful, and highlight positive or negative trends for a company. While two different business could both show a current ratio of 1.0 during a financial year, one could have reached that ratio after a downward trend over several years, while the other could be increasing their ratio year on year.
An important thing to remember is that current ratio is only useful when comparing against other very similar companies in the same industry, as comparing to a business with a very different operational model might be misleading or ultimately fruitless.
It’s also worth remembering that while the current ratios of two businesses might appear very similar, they can represent very different types of assets, some of which may be more easily liquidated than others. For example, one company could have a large amount of cash in the bank, while the other holds a large amount of stock. Naturally the latter is harder to turn into a liquid asset.
Calculating the Current Ratio
The formula for current ratio is the total value of current assets divided by the total value of current liabilities. This gives you the ratio number, which should be somewhere in the region of 1.0.
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