Current Ratio is a liquidity ratio that measures a company’s ability to pay its current liabilities with revenue earned from its current assets. The current ratio is also sometimes referred to as the working capital ratio and displays the relationship between the assets of a company that can be converted within one year and the liabilities that are to be paid out in about one year.

This is calculated by simply dividing the existing assets by the current liabilities. Short-term provisions include those expected to be due within one year, such as short-term bank loans, payable accounts, salaries and loan repayments.

How to calculate Current Ratio?

The current ratio is calculated by dividing the present assets by the current liabilities. This ratio will be available in a numeric format rather than a decimal format.

Current ratio = current assets/  current liabilities

How to interpret a Current Ratio?

Let’s see some of the assumptions that can be derived from the obtained Current Ratio:

In general, a current ratio between 1.5 to 2 is considered beneficial for the business, meaning that the company has substantially more financial resources to cover its short-term debt and that it currently operates in stable financial solvency.

An unusually high current ratio may indicate that the business isn’t managing its capital efficiently to generate profits.

On the other hand, a lower current ratio (especially lower than 1) would signify that the company’s current liabilities exceed its current assets and that the business may not be able to cover its short-term debt (if it were due all at once) with its current financial resources.

Either way, there is no clear line between what makes a current ratio good or bad because companies within different industry groups will also have different standards of current ratios. This is why it’s important to compare the current ratio of a company with its industry peers rather than treating all types of companies the same.

Another important point to note is that the current ratio should not be analyzed in isolation over a given time frame. Over a period of time, we can take a close look at this ratio- whether the ratio is gradually rising or declining. However, you will note in several instances that there is no such clear pattern. Instead, the new ratios provide a definite hint of seasonality.

What are the benefits of Current Ratio?

  • The current ratio shows the overall performance of the firm in meeting the issuer’s necessities. It also provides a better understanding of the management of the company’s working capital.
  • It helps us to assess the brief financial health of a company. The higher the ratio, the more stabilized the company will be. The lower the ratio, the higher will be the financial risk associated with the company.
  • The current ratio makes it easier to understand how efficient a company is in making sales; – i.e., how swiftly the company is able to convert its current assets into cash. Thus the current ratio provides an insight into the operating cycle of a company. Having a clue about that, a company can streamline its production. 

What are the limitations of Current Ratio?

  • The major downside of the current ratio is that the ratio is not a sufficient indicator of the company’s liquidity and working capital.
  • The volatility of the current ratio will lead to a misperception of the liquidity of the company.
  • The other limitation of the current ratio is that the inventory is included in the calculation of the current assets. Inventory may often take more than one to be turned into cash or revenue for the firm. If the company has a high inventory stock level, it will indicate that a company is in an excellent liquidity position, but in a practical sense, it is in grave fiscal viability.
  • Equal change in assets and liabilities can result in a change in the ratio.
  • Lastly, if the sales are seasonal, the company may have an inconsistent current ratio. If sales are low, the company will record the lowest current ratio, but the current ratio will be high when sales increase.

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