Reviewed by Oct 05, 2020| Updated on
The current ratio is the liquidity ratio which measures the company’s capability to standby their short-term liabilities and obligations, specifically the ones that are to be paid within a period of twelve months. It indicates to the investors and analysts that how well the company is capable of optimising the existing assets in its balance sheets to take up the responsibility of its debt and other liabilities.
To calculate the current ratio, investors and analysts will compare the company’s existing assets with its existing liabilities. Current or existing assets that are listed in the company’s balance sheets include accounts receivable, cash, inventories, and other assets that are anticipated to undergo the process of liquidation or being converted into cash within the period of twelve months.
Current or existing liabilities include taxes due, wages, accounts payable, and the existing portion of the long-term debt. Given below is the formula to calculate the current ratio:
Current ratio = Current Assets / Current Liabilities
The current ratio, which is in sync with the industry standards or somewhat higher, is usually accepted by investors and analysts. The current ratio that is slightly lower than the industry average will imply that there is a possibility of a higher risk of default or distress.
Likewise, if the company has a very high current ratio among its competitors or peers, then it implies that the company’s management is not utilising the company’s assets effectively.
A current ratio of less than one can indicate that there are some underlying problems in the company. Nevertheless, several situations are affecting the current ratio of a well-established company.
The current ratio is generally referred to as ‘current’. Unlike other ratios related to liquidity, it includes every current liability and asset. The current ratio is also referred to as the working capital ratio by analysts.