The Current Ratio (CR) measures a company’s ability to pay Current Liabilities (CL) with its Current Assets (CA).
CA also called Short-Term Assets (Cash, Inventory, Receivables) are located on the balance sheet and represent the value of all assets that can reasonably expect to be converted into cash within one year. The following are examples of Current Assets:
- Cash and cash equivalents (Cash)
- Marketable securities or Short-Term Investments (STI)
- Accounts receivable (ST A/R)
- Prepaid expenses
- Inventory (INV)
CL also called Short-Term Liabilities (Debt and Payables) are a company’s debts or obligations that are due within one year, also appearing on the company’s balance sheet. The following are examples of current liabilities:
- Short-term debt (STD)
- Accounts payables (ST A/P)
- Accrued liabilities and other debts
Calculating the Current Ratio
Since the CR shows the proportion of CA to CL, it’s calculated by dividing CA by CL as shown in the formula below:
Let us see some results:
| CR value | Meaning | Meaning |
| less than 1 | fewer CA than CL | Cash problem. To be considered as a financial risk by creditors since it would signal that the company might not be able to easily pay down their Short-Term obligations |
| more than 1 | more CA than CL | Signifies that a company is liquid and as a result, could liquidate their CA more easily to pay down their Short-Term Liabilities |
| 1.5 – 2.5 | CA almost twice as much CL | Preferable and desirable value. Smooth business operations. Efficient Management of Working Capital |
| more than 2.5 | CA too high relative to CL | Not efficient Management of Working Capital. To much Working Capital involved in Business. |
Notes:
- check CR values with Industry norms (i.e. Supermarkets operate with lower CR because they low debtors)
- check trends – different WC management
