Current Ratio
What is the Current Ratio?
The Current Ratio is a liquidity ratio, which calculates how well a company can settle its short-term obligations (debts and liabilities within a year) with its short-term assets (assets that can be converted to cash within a year). It shows the company's short-term financial health.
Current Ratio Formula
Current Ratio = Current Assets/Current Liabilities
Current Assets: Cash, accounts receivable, inventory, marketable securities, etc.
Current Liabilities: Accounts payable, short-term loans, accrued expenses, etc.
Example
If a company possesses:
Current Assets = ₹10 crore
Current Liabilities = ₹5 crore
Current Ratio = 10/5 = 2.0
It indicates that the company possesses ₹2 of current assets for each ₹1 of current liabilities.
Interpretation
| Current Ratio | Meaning |
|---|---|
| > 1 | Company can cover its short-term liabilities comfortably |
| = 1 | Just enough assets to cover liabilities |
| < 1 | Potential liquidity issues; may struggle to pay debts |
Ideal Range: Typically between 1.5 to 2 is considered healthy, but this can vary by industry.
Usefulness of the Current Ratio
- Liquidity Test: Used to determine whether a business has the ability to pay short-term obligations.
- Creditor Confidence: The greater the ratio, the greater lender and supplier confidence.
- Financial Planning: It aids management in maintaining effective working capital.
Drawbacks
Doesn't Account for Asset Quality: Inventory may not be readily marketable or receivables may be slow to pay.
Snapshot Perspective: Is a snapshot in time and might not show seasonal fluctuations.
Is Easy to Manipulate: Companies can temporarily jack up current assets (e.g., by slowing down payments).