#current ratio formula

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Understanding Liquidity Ratios: Current Ratio Explained with Examples

The current ratio is a key liquidity ratio used to assess a company’s short-term financial health. Learn its meaning, formula, and limitatio

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Current Ratio

The current ratio, commonly referred to as the current liquidity ratio or the working capital ratio, is one of the most important liquidity measures to assess a business’ performance. This post will take a dive into the concept of the current ratio and its interpretation, along with an example.

The current ratio measures a business’ ability to meet its short-term obligations that are due within a year. Further, this ratio is a measure of the financial health and solvency of a business, as it indicates how a business can maximize the liquidity of its current assets to settle debt and payables.

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Current Ratio Formula and Interpretation

The current ratio is a famous financial ratio among the finance experts and analysts to gauge a company's liquidity (likewise alluded to as a company's working capital). It is determined by dividing the company's current assets by current liabilities. The ratio estimates the liquidity/working capital management of the company.

It gives a plan to the potential investor whether the company generates sufficient cash to take care of its current liabilities. The higher the ratio, the more current assets a company has contrasted with its liabilities.

The ratio should be analyzed and benchmarked with the industry in which the Company operates and benchmarking could give better analysis if the ratio is analyzed over the period of time, let say for instance two to the years and in some cases five years.

The company faces liquidity issues when they are unable to increase their receivables collections.

A current ratio below one does not indicate that the company will go bankrupt or will be unable to pay its short-term debts, however, it indicates that the company may need to revisit its credit terms with receivables and trade payables as the company may be in the poor financial state.

Then again, a ratio that is too high may reflect that the company isn't proficiently utilizing its current assets or liabilities. A current ratio equal to one is considered an ideal current ratio.

Here is the current ratio formula:

Current Ratio Formula Example-1Ali’s Truckista Snack Center sells fast food items in Karachi. Ali is applying for a loan to open more Truckista snack centers in the Karachi suburb as a business expansion strategy. Ali’s bank asks for his balance sheet so they can analyze his current liquidity position. According to Ali’s balance sheet he reported Rs.200,000 of current liabilities and Rs.400,000 of current assets.

Ali’s current ratio would be calculated as:

Current Ratio = Current assets / Current liabilities

Current ratio= Rs.400,000/Rs200,000

Current ratio = 2

As you can analyze, Ali has enough current assets to pay back its current liabilities. This shows that Ali’s business is less leveraged and also has a negligible risk. Banks always prefer a current ratio of more than one, so that all the current liabilities could be covered by current assets. Since Ali’s current ratio is more than one, it is for sure that he will get approved for his loan as a part of his business expansion strategy.

Current Ratio Formula Example-2If you go through the balance sheet of any company you can see current assets includes cash & cash equivalents, short-term deposits, marketable securities, trade & account receivables, inventories, prepaid expenses, and other current assets, and current liability includes short-term debt to be repaid within one year, trade & account payables, current portion of long-term debt, accrued expenses, taxes payables, deferred revenue, and other current liabilities.

For example - A firm has Rs. 1.0 million in total current assets and Rs. 2.0 million in total current liabilities. Its current ratio is calculated as:

Current Ratio = Current assets / Current liabilities

Current ratio = Rs. 1,000,000/Rs.2,000,000

Current ratio = 0.5

From the above calculation we can say that for every rupee in current liabilities, there is only Rs. 0.5 in current assets. This means business is highly leveraged and also has high risk.