Financial Analysis – Current Ratio (CR)

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 valueMeaningMeaning
less than 1fewer CA than CLCash 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 1more CA than CLSignifies that a company is liquid and as a result, could liquidate their CA more easily to pay down their Short-Term Liabilities
1.5 – 2.5CA almost twice as much CLPreferable and desirable value. Smooth business operations. Efficient Management of Working Capital
more than 2.5CA too high relative to CLNot 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

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