The Current Ratio formula gives a value which is a type of “liquidity ratio” and shows a company’s ability to pay its short-term obligations – short term refers to the next 12 months.
In other words it is a formula to show a company’s ability to pay out its short-term (12 month) liabilities (debts and payables) using its short-term assets (cash, inventory, receivables).
The formula to calculate the ratio as follows:
Current Ratio = (Current Assets / Current Liabilities)
The higher the current ratio, the more capable the company is capable of paying its obligations, and a value over 2 is generally desired. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point (assets are less than the liabilities). While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt – as there are many ways to improve a business by sales and financing – but it is definitely not a good position to be in for too long.
The current ratio also gives a sense of the “efficiency” of a company’s operating cycle, that is, its ability to turn its product into cash. Companies that have trouble being paid on their receivables on time or with long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies within the same industry.
The ratio is similar to the acid-test ratio except that the acid-test ratio takes out inventory and pre-paids or deposits as assets that can be liquidated, as they can take longer (weeks, months). The components of current ratio (current assets and current liabilities) can be used to calculate working capital (which is the difference between current assets and current liabilities). Working capital is also used to calculate the working capital ratio, which is working capital as a ratio of sales.
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