Current Ratio –
The current ratio is a liquidity ratio that shows a company’s ability to pay off its short-term liabilities with current assets. This ratio is very popular across the industry and is used to check the short-term liquidity of a firm. This ratio includes only current assets or short-term assets and current liabilities or short-term liabilities. The ratio is also known as Working Capital Ratio.
Current Assets means assets which are used or utilized within one year, and Current Liabilities means liabilities (debt) which are repaid within one year.
Current Ratio = Current Assets / Current Liabilities
- Current Assets = Cash, Cash equivalents, Marketable securities, Accounts receivable, Notes receivable, Inventory etc.
- Current Liabilities = Notes payable, Accounts payable, Dividend payable to shareholders, Short term loans from banks, short term loans from institutions etc.
Lets take examples,
Lets talk about Company A, Current assets are 115 and current liabilities are 75, so if we calculate current ratio of company A is
= 115 / 75
Current Ratio of Company A = 1.53
Lets talk about Company B, Current assets are 170 and current liabilities are 170, so if we calculate current ratio of company B is
= 170 / 170
Current Ratio of Company B = 1
Lets talk about Company C, Current assets are 95 and current liabilities are 135, so if we calculate current ratio of company C is
= 95 / 135
Current Ratio of Company C = 0.7
Now we have calculated current ratio of company A, B, And C
Ratio of company A = 1.53
Ratio of company B = 1
Ratio of company C = 0.7
From this ratio we can say that, Company A has ratio of 1.5 which is higher than B and C which means company A is in strong position as compared to B and C because it is capable of paying its short term liabilities comfortably. Company B has ratio of 1, it means company’s assets are able to cover its liabilities or debt that are due at the end of the year. Company C has ratio of 0.7, it means company C may have problems meeting its short term obligations.
Before investing we need to check this ratio, if it is higher than 1 it means it is good investment. Also we need to understand the ratio should be increasing not decreasing. We should study which factor is affecting the this ratio, and in future how that is going to affect.
The Ratio above 3 indicates that company might not utilizing its assets correctly.
Ratio > 1 means company is capable of paying its short term liabilities comfortably.
Ratio = 1 means company’s assets are able to cover its short term liabilities.
Ratio < 1 means company may have problems meeting its short term liabilities.