The current ratio is a liquidity ratio that calculates a company’s ability to meet its short-term debt and obligations, or those due in a single year, using balance-sheet assets. The working capital ratio is another name for it. Investors prefer a current balance of one or more. It is less than one indicates that the company may be unable to service its short-term debt. On the other hand, a current balance more significant than one can suggest that the company has an excess of unsold inventory or cash on hand.
Calculating the Current Ratio
Current assets constitute the total assets that will be used or converted to cash in the coming year. Cash, inventory, and accounts receivable are all on this list. Current liabilities are the total of all liabilities due within the following year. Wages, accounts payable, mortgage payments, and loans are all on this list. A company’s ideal current ratio is 0.6 if it has $100,000 in existing assets and $150,000 in current liabilities.
What Is the Ratio Used?
It can differ depending on the industry, company size, and economic conditions. For example, consumer goods industries with predictable, recurring revenue often have lower ratios, whereas cyclical sectors, such as construction, have high ratios. In addition, it can vary between companies, even within the same industry. Supplier agreements, for example, can affect the number of liabilities and assets. A large retailer, such as Walmart, may negotiate favourable terms with suppliers, such as keeping inventory for extended periods and having generous payment terms or liabilities.
What Is an Appropriate Ratio?
During periods of economic expansion, investors prefer lean companies with low ratios and demand dividends from companies with high ratios. During a downturn, however, they flock to companies with high ratios because they have existing assets that can help them weather the storm. Unfortunately, ratios are only sometimes a good indicator of a company’s liquidity because they assume that the company can convert all inventory and purchases to cash immediately.
This may only sometimes be the case, particularly during economic downturns. Acid-test ratios are used in such cases because they subtract inventory from asset calculations to calculate immediate liquidity.
About Finline!
Finline is an online platform for creating financial reports for getting bank loans and investments. It’s like ‘Canva’ but for financials. If you are an entrepreneur looking for a bank loan, you need to have a well-crafted project report. We, at Finline help you with that. Our team will help you create a powerful business plan in ten minutes. That too in your language. All public and private sector banks working in India accept our reports. Click to create your report.