Current Ratio

The current ratio assesses a company's liquidity by comparing its current assets to its short-term liabilities, due within a year.
Current Ratio
3 min
06-June-2024

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 is a financial tool that measures how capable a company is of meeting its short-term liabilities or current liabilities. Also known as the working capital ratio, this tool compares the current assets of a company with its 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.

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.

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.

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.

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.

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.

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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Frequently asked questions

Is a current ratio of 1.5 considered good?

A current ratio of 1.5 is generally considered a healthy sign of liquidity in a company.

How is the current ratio different from the quick ratio?

The current ratio takes the current assets into account, while the quick ratio only considers liquid/quick assets and does not include inventory.

What is the best way to measure a company’s liquidity?

You can use financial measures like the current ratio and the quick ratio to assess the level of liquidity in a company.

Why is liquidity important for companies?

Liquidity is important for companies because it ensures that they have enough liquid assets to meet their short-term liabilities and debts. Without adequate liquidity, companies will have to resort to additional debt or redeem their long-term assets to meet short-term debts.

What is a good value for the current ratio?

Any value above 1 is a good sign. As a rule of thumb, a current ratio of 1.5 or higher may be a healthy sign of liquidity.

What does a current ratio of 0.5 indicate?

A current ratio of 0.5 means that the company only has enough current assets to meet half of its current liabilities. It is a sign that the company may have liquidity issues.

What does it mean if the current ratio is below 1?

A current ratio of less than 1 means that the company does not have enough current assets to redeem and pay for its current short-term liabilities.

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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.