The current ratio is balance-sheet financial performance measure of company liquidity.
The current ratio indicates a company's ability to meet short-term debt obligations. The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months. Potential creditors use this ratio in determining whether or not to make short-term loans. The current ratio can also give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. The current ratio is also known as the working capital ratio.
The current ratio is calculated by dividing current assets by current liabilities:
The current ratio = Current Assets / Current Liabilities
Both variables are shown on the balance sheet (statement of financial position).
Norms and Limits
The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's a comfortable financial position for most enterprises. Acceptable current ratios vary from industry to industry. For most industrial companies, 1.5 may be an acceptable current ratio.
Low values for the current ratio (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, an investor should also take note of a company's operating cash flow in order to get a better sense of its liquidity. A low current ratio can often be supported by a strong operating cash flow.
If the current ratio is too high (much more than 2), then the company may not be using its current assets or its short-term financing facilities efficiently. This may also indicate problems in working capital management.
All other things being equal, creditors consider a high current ratio to be better than a low current ratio, because a high current ratio means that the company is more likely to meet its liabilities which are due over the next 12 months.
Exact Formula in the ReadyRatios Analytic Software
Current ratio = F1[CurrentAssets]/F1[CurrentLiabilities]
F1 – Statement of financial position (IFRS).
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- Financial education
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