The current ratio indicates a company's capability to fulfil short-term obligations. It is calculated by dividing current assets by current liabilities. Current assets are those convertible to cash in a year, while current liabilities are due within a year.
Before you invest in a company over the long term, there are various aspects you need to look into to decide if the entity makes for a good investment. In addition to the company’s valuation, profitability and long-term growth prospects, you also need to assess its liquidity. Financial liquidity ratios like the current ratio can help you with this.
In this article, we discuss the meaning of the current ratio, check out the current ratio formula and computation and see what the ideal value for this ratio is.
What is current ratio?
The current ratio, another name for the working capital ratio, is a financial measure of a company's ability to handle its upcoming bills (within a year). It simply compares what a company owns that can be turned into cash soon (current assets) to what it owes that needs to be paid soon (current liabilities). By assessing the current ratio, you can get a better idea of whether or not a company has enough cash and cash equivalents to meet its short-term debts.
When you are evaluating a company’s worthiness for long-term investment, you should check its current ratio as a standalone factor and also see how it compares with the industry standard. This will give you a comprehensive picture of the company’s liquidity.
Formula of current ratio
Now that you know the meaning of the current ratio, let us take a closer look at the current ratio formula. Based on the definition, we know that this ratio compares the current assets and the current liabilities of a company. So, the formula for this ratio is as follows:
Current ratio = Current assets ÷ Current liabilities
How to calculate current ratio?
To calculate the current ratio, you need to ensure that you have the required information and then use the current ratio formula shown above to arrive at the ratio. Here is a step-by-step guide to calculating the current ratio.
- Step 1: Find the current assets of the company for the period you are interested in. You can get this data from the company’s balance sheet.
- Step 2: Identify the company’s current liabilities for the same period. This data is also available in the balance sheet.
- Step 3: Divide the company’s current assets by the current liabilities to arrive at its current ratio for the period concerned.
Components of current ratio
The current ratio compares a company’s current assets and liabilities. To understand how this tool measures liquidity, you need to be familiar with the components of the ratio. Let us see what each component means.
Current assets
The current assets of a company are those assets that can easily be redeemed for cash or liquidated. Some examples of such assets include cash, accounts receivables, inventory, prepaid expenses and the like.
Current liabilities
Current liabilities include short-term debts that typically need to be repaid within one year or during one operating cycle. Some examples of current liabilities include accrued expenses, short-term debts, accounts payable and the like.
Also read: What is the interest coverage ratio
Example of Current ratio
To better understand the current ratio formula and how it works, let us discuss a hypothetical example. Consider the following details from a company’s financial statements:
Current assets:
- Cash and cash equivalents: Rs. 1,50,000
- Accounts receivable: Rs. 3,00,000
- Inventory: Rs. 2,00,000
Current liabilities:
- Accounts payable: Rs. 2,50,000
- Short-term debts: Rs. 1,00,000
- Accrued expenses: Rs. 50,000
This gives us a total current asset value of Rs. 6,50,000 and a total current liability value of Rs. 4,00,000. So, the current ratio is 1.625.
What is an ideal current ratio?
A current ratio of 1 indicates that the company has just enough current assets to meet its short-term or current liabilities. Ideally, the current ratio should be more than 1 because it points to a surplus in the company’s current assets. As a rule of thumb, a current ratio of 1.5 or higher is considered a sign of adequate liquidity in a company.
However, it is not enough to check the current ratio on a standalone basis. You must also compare the current ratio of a company with its peers in the industry to evaluate whether the company has above-average or below-average liquidity. Furthermore, you can also compare a company’s current ratio for any given financial year with its ratio during the previous fiscal periods to see how its liquidity has changed with time.
Also read: What is total expense ratio (TER)
Why the current ratio is important?
The current ratio of a company is important because it gives you a clear insight into the entity’s liquidity and short-term financial health. It helps you assess the company’s capacity to repay its short-term obligations using its short-term or current assets. By evaluating a company’s current ratio for any given financial year, you can decide if it is sufficiently liquid or having trouble meeting its short-term obligations. Furthermore, you can also compare a company’s current ratio across different consecutive periods to better understand how effectively or poorly the entity has been managing its current assets.
Who uses this ratio?
The current ratio is a valuable tool used by a wide range of financial stakeholders in the UK. Here are some of the most common users:
- Creditors: Banks and other lenders use the current ratio to assess a company's ability to repay short-term loans and debts. A high ratio indicates a lower risk of default.
- Investors: Potential investors consider the current ratio to evaluate a company's financial health and short-term liquidity. A strong ratio suggests the company can meet its upcoming obligations.
- Management: Businesses themselves use the current ratio to monitor their working capital management and identify potential shortfalls in meeting short-term liabilities.
- Analysts: Financial analysts employ the current ratio alongside other metrics to assess a company's overall financial stability and risk profile.
Limitations of the current ratio
Despite its advantages, the current ratio also has its limitations. It does not account for the types of current assets a company has. As a result, the analysis may be skewed. For instance, a company may have a high current ratio due to a large amount of inventory, but this does not necessarily mean that it can easily convert that inventory into cash.
Another limitation is that it does not consider the timing of cash flows. A company may have enough current assets to cover its current liabilities, but if those assets are not realised in time to meet obligations, it could still face liquidity issues.
Also read: What is a Sharpe Ratio in Mutual Funds?
Key takeaways
- The current ratio is a financial metric that indicates a company's ability to pay off its short-term liabilities (due within a year) using its current assets (convertible to cash within a year).
- It is calculated by dividing the company's current assets by its current liabilities. A ratio of 1 indicates that the company has just enough current assets to cover its short-term liabilities. A ratio greater than 1 suggests a surplus in current assets, and a ratio less than 1 indicates a shortage.
- Ideally, a company should have a current ratio greater than 1, but a very high ratio may indicate that the company is not using its cash effectively.
- It is important to compare a company's current ratio with its industry peers to get a better understanding of its liquidity.
- The current ratio is a useful tool for creditors, investors, businesses, and analysts to assess a company's short-term financial health.
Conclusion
The current ratio is just one of the many financial metrics that you need to look into before you invest in a company over the long term. You also need to perform extensive fundamental analysis and assess the valuation of a company before investing in its stock. If you do not have the time or the expertise for this and if you are looking for expert management of your investments, mutual funds may be the answer.
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