What is Current Ratio?
Current Ratio is a primary liquidity ratio that measures the capability of a company to pay maturing short-term debts.
The current ratio is sometimes called the working capital ratio.
What is the Formula of Current Ratio?
This ratio is calculated by dividing current assets by current liabilities.
Below is the formula for Current Ratio:
What comprise current assets?
Current assets are comprised of the following:
- Cash and cash equivalents
- Accounts receivables
- Notes receivables
- Marketable securities
- Other short-term investments
- Other current assets
What comprise current liabilities?
- Accounts payable
- Short-term notes payable
- Accrued expenses
- Accrued taxes
- Other debts payable within a year
Below is a balance sheet of ABC Company. You are asked to solve the current ratio for year and explain the result.
Using the formula, we will get 12.36x ($13,150,000 divided by $1,063,500). This actually a pretty high current ratio. But is this good at all?
Depending on the industry, the current ratio benchmark varies. A 12.36x current ratio means that a company is less like to fall behind in paying short-term debts. This is because, for every dollar debt, ABC Co. has $12.36 available to pay it off.
Having a very high current ratio
However, having a very high current ratio may indicate inefficient use of current assets. This is costly!
For instance, a high concentration of cash is not efficient for a company. It is better to invest a portion of the stagnant cash to investment vehicles with reasonable yield and risk.
Having a very high accounts receivable balance and very high inventory balance indicates inefficiencies as well. These ultimately result in high costs such as high uncollectible accounts and high cost of carrying and risks of loss and shrinkage for inventories.
Having a current ratio of less than 1x
Having a current ratio of less than 1x may result in a high risk the company not being able to pay its debt when it comes due.
Depending on the situation, it may also indicate that the company may have low accounts receivable or inventory balance.
Low accounts receivable may indicate a strict collection policy which can hurt total sales.
Low inventory balance can also lead to risk of stockout.