Current Ratio- Formula, Interpretation & Example

• Dec 16, 2021
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After purchase, the company can issue invoices as quickly as possible, establishing clear payment terms at the outset such as late fees and interest on past-due balances. Companies can conduct a close review of the business’ accounts payable process and look for inefficiencies that delay payments and prevent prompt collections. Enhancing asset management in the company can help increase the current ratio of the company. For instance,with a sweep account, the cash on hand of the company can earn interest while remaining available for operating expenses. These accounts sweep excess cash into an interest-bearing account and then return this excess cash to the operating account when it’s time to pay bills. A good current ratio is when the assets of a company exceed its liabilities.

More investigation may be needed because there is a probability that the accounts payable will have to be paid before the entire balance of the notes-payable account. More so, Company X has fewer wages payable, which is the liability most likely to be paid in the short term. As a result, you must remember that the current ratio is only one lens into the health of your business’s financial position. Always supplement it with deeper financial analysis to better inform your decisions. Current assets refer to assets you can expect to convert to cash within one year.

Understanding the Current Ratio

Companies with an improving current ratio may be undervalued and in the midst of a turnaround, making them potentially attractive investments. This is arrived at by dividing current assets by current liabilities. The first way to express the current ratio is to express it as a proportion (i.e., current liabilities to current assets). It is worth knowing that the current ratio is simpler to calculate, but sometimes it is less helpful than the quick ratio because it doesn’t make a distinction between the liquidity of different types of assets.

• To estimate the credibility of Mama’s Burger, the bank wants to analyze its current financial situation.
• So a current ratio of 4 would mean that the company has 4 times more current assets than current liabilities.
• For example, a company’s current ratio may appear to be good, when in fact it has fallen over time, indicating a deteriorating financial condition.
• The current ratio is an important measure of liquidity because short-term liabilities are due within the next year.
• Accountants also often use this ratio since accounting deals closely with reporting assets and liabilities on financial statements.

What is considered a good current ratio for a company will depend on the company’s industry and historical performance. Generally, current ratios of 1 or greater would indicate ample liquidity. The company can also consider selling unused capital assets that don’t produce a return.

What Is the Current Ratio?

Even from the point of view of creditors, a high current ratio is not necessarily a safeguard against non-payment of debts. By contrast, in the case of Company Y, 75% of the current assets are made up of these two liquid resources. The current ratio is one of the oldest ratios used in liquidity analysis. One limitation of the current ratio emerges when using it to compare different companies with one another. Businesses differ substantially among industries; comparing the current ratios of companies across different industries may not lead to productive insight.

This is based on the simple reasoning that a higher current ratio means the company is more solvent and can meet its obligations more easily. The owner of Mama’s Burger Restaurant is applying for a loan to finance the extension of the facility. To estimate the credibility of Mama’s Burger, the bank wants to analyze its current financial situation. The current ratio reflects a company’s capacity to pay off all its short-term obligations, under the hypothetical scenario that short-term obligations are due right now.

Current Ratio Formula, Calculation and Examples

The current liabilities, on the other hand, include wages, accounts payable, short-term debts, taxes payable, and the current portion of long-term debt. Therefore, the current ratio measures a company’s short-term liquidity with respect to its available assets. Current ratios measure the ability of a company to pay its short-term or current liabilities (debts and payables) with its short-term or current assets, such as cash, inventory, and receivables. The current ratio formula and calculation is an example of liquidity ratios used to determine a company’s ability to pay off current debt obligations without raising external capital. The current ratio, quick ratio, and operating cash flow ratio are all types of liquidity ratios.

So make sure your current liabilities don’t exceeds your current assets for the betterment of your company financial condition. However, a high current ratio may also indicate that a company is not using its current assets efficiently and may have excess inventory or cash on hand. The Current Ratio is a financial metric that indicates a company’s current ratio equation ability to pay off its short-term liabilities with its short-term assets. As a measure of a company’s financial stability, the current ratio is an essential component of any comprehensive financial analysis. But, during recessions, they flock to companies with high current ratios because they have current assets that can help weather downturns.