Definition
The current ratio, also known as the working-capital ratio, is a key financial metric used to evaluate the liquidity of a business. It measures the ratio of current assets to current liabilities, indicating a company’s ability to cover short-term obligations with short-term assets. For example, if a company’s current assets are £250,000 and its current liabilities are £125,000, the current ratio would be 2:1.
Formula:
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]
Interpretation:
- Below 1:1: Indicates potential liquidity issues; the company may struggle to meet its short-term obligations.
- Above 2:1: May suggest inefficient management of working capital.
Examples
Example 1
A retail business has:
- Current Assets: $300,000
- Current Liabilities: $150,000
Current Ratio = $300,000 / $150,000 = 2:1
Example 2
A manufacturing company has:
- Current Assets: $500,000
- Current Liabilities: $600,000
Current Ratio = $500,000 / $600,000 = 0.83:1
Frequently Asked Questions (FAQs)
What is considered a good current ratio?
A current ratio between 1.5:1 and 2:1 is often seen as ideal, suggesting the company has enough assets to pay off its short-term liabilities, but is not excessively hoarding cash and thus keeping working capital efficient.
What does a low current ratio indicate?
A low current ratio (e.g., under 1:1) can signal that a company might have trouble paying its short-term obligations, potentially indicating liquidity issues or financial distress.
What does a high current ratio suggest?
A high current ratio (e.g., above 2:1) might indicate poor management of working capital, suggesting the company has more assets tied up in current assets than necessary, which could otherwise be invested in growth opportunities.
How does the current ratio differ from the quick ratio?
While the current ratio includes all current assets, the quick ratio (or acid-test ratio) excludes inventory and other less liquid current assets, providing a more stringent test of a company’s short-term liquidity.
Related Terms
Current Assets
Assets that are expected to be converted into cash or used up within one year, such as cash, inventory, and accounts receivable.
Current Liabilities
Obligations that a company needs to settle within one year, including accounts payable, short-term loans, and other similar debts.
Working Capital
The funds available to a company for day-to-day operations, calculated as current assets minus current liabilities.
Quick Ratio
A measure of liquidity similar to the current ratio but excludes inventory from current assets to provide a more stringent assessment.
Inventory Turnover Ratio
A measure of how efficiently a company manages its inventory, calculated as the cost of goods sold divided by average inventory.
Online References
- Investopedia: Current Ratio
- Accounting Tools: Current Ratio Definition
- Corporate Finance Institute: Current Ratio Formula
Suggested Books for Further Studies
- “Financial Accounting” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
- “Accounting for Dummies” by John A. Tracy and CPA Tage C. Tracy
- “Principles of Accounting” by Belverd E. Needles, Marian Powers, and Susan V. Crosson
Accounting Basics: “Current Ratio” Fundamentals Quiz
Thank you for exploring the nuances of the current ratio and testing your financial knowledge! Keep striving for excellence in understanding and managing financial metrics.
