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Current Ratio
Definition of
Current Ratio
What is the Current Ratio? The Current Ratio, also known as the working capital ratio, is a liquidity ratio that measures a company's ability to pay its short-term liabilities (due within one year) with its current assets (assets expected to be converted to cash within one year). It indicates a company's short-term financial health and operational efficiency. The formula for the current ratio is: Current Ratio = Current Assets / Current Liabilities. Understanding this ratio is crucial for effective cash flow management.
Activities Related to
Current Ratio
Here is a list of activities related to the Current Ratio: Identifying and summing all current assets from the Balance Sheet (e.g., cash, accounts receivable, inventory, prepaid expenses). Identifying and summing all current liabilities from the Balance Sheet (e.g., accounts payable, short-term debt, accrued expenses). Calculating the ratio. Comparing the current ratio to industry averages and the company's historical ratios to assess trends and performance. Using the ratio as part of financial statement analysis to evaluate short-term financial risk. Making decisions regarding working capital management.
The Importance of
Current Ratio
The Current Ratio is important as it provides a quick assessment of a company's ability to meet its short-term financial obligations. A ratio greater than 1 generally suggests that a company has more current assets than current liabilities and is likely capable of paying off its obligations. However, a very high ratio might indicate inefficient use of assets (e.g., too much cash idle or excess inventory). A ratio below 1 may suggest potential liquidity problems. Lenders and creditors often use this ratio to determine a company's creditworthiness for short-term loans. It's a key metric for cash flow monitoring and ensuring solvency.
Key Aspects of
Current Ratio
Indicator of Short-Term Liquidity
Measures the ability to pay debts due within one year.
Comprehensive Current Assets
Includes all assets expected to be converted to cash within a year, including less liquid ones like inventory.
Widely Used
A common and fundamental financial ratio used by analysts, investors, and creditors.
Context is Key
Interpretation should consider industry norms and company-specific circumstances; it's often compared with the Quick Ratio and Cash Ratio for a fuller picture.
Concepts Related to
Current Ratio
The Current Ratio is a primary Liquidity Ratio, alongside the Quick Ratio (which excludes inventory and prepaids) and the Cash Ratio (which only includes cash and cash equivalents). It's calculated using data from the Balance Sheet and is crucial for understanding a company's working capital position. Accurate bookkeeping is essential for a reliable calculation. For more on how ratios are used, see our Performance Ratios report page.
Current Ratio
in Action:
The Adventures of Coco and Cami
Cami wants to know if her boutique has enough short-term assets (like cash, money owed by customers, and her inventory of clothes) to cover its short-term liabilities (like upcoming supplier payments). Professor A introduces the Current Ratio. He explains that if this ratio is above 1, it generally means she's in a good position to pay her bills.
Coco calculates her bakery's current ratio too. They both learn that while a good current ratio is important, having too much inventory that isn't selling quickly could make the ratio look better than the actual cash situation. This is why it's also good to look at the Quick Ratio.