Current Ratio Explained - Examples, Analysis, and Calculations

What is the Current Ratio?

The current ratio definition implies that it is an indicator informing investors about the company’s ability to pay off any obligations that are due for one year. Also known as Liquidity Ratio or Working Capital Ratio, it gives an idea about a company’s financial stability and tells analysts how it can increase the current assets to be better able to pay off its short-term liabilities.

An acceptable Current Ratio denomination varies across industries utilizing various calculating systems. A Current Ratio higher than industry standards is considered favourable, while one that is lower could indicate high risk. On the flip side, if the Current Ratio is too high and calculated to be 3, then it means that the business is not utilizing its assets in an optimum manner nor is it managing the liabilities properly.
 

Components of Current Ratio

The two most important parts of the Current Ratio are Current Assets and Current Liabilities.

Assets that can be turned into cash or equivalents of cash are Current Assets and may include the following:

●    Cash
●    Cash Equivalents
●    Short-term Investments
●    Inventory/ Stock
●    Accounts Receivable
●    Expenses that are already paid for

Assets that are obligations due to be paid to others are Current Liabilities, and may include the following:

●    Accounts Payable
●    Short-term Debts
●    Outstanding Wages
●    Income Tax Payable

How to Calculate the Current Ratio

The Current Ratio formula is derived by dividing the total current assets by the total current liabilities.

The formula to calculate it is
Current Ratio = Total Current Assets/Total Current Liabilities

The result of this calculation determines the number of times the business could pay off its current liabilities with its current assets.
 

Calculation of Current Ratio Example

The table below shows the calculation for a hypothetical company. This example of the current ratio will help gauge the health of the said company and can also help future investors make an informed decision.

Now, as per the current ratio definition
Total Current Assets = 11,40,75,100
Total Current Liabilities = 6,70,87,124

Based on the formula,
Current Ratio = 11,40,75,100/6,70,87,124
                        = 1.7

This business has a ratio of 1.7, which means that it can clear its loans almost 2 times with the help of its current assets.

A ratio of more than 1 is suitable and anything less than 1 is unsuitable.

In this case, the ratio tells us that the business can meet its liabilities through its current assets and that it has a conducive financial status.
 

Analysis of Current Ratio

A good Current Ratio revolves around multiple factors:

●    Age of the business
●    Competitors in the industry
●    Financial Goals

While a higher ratio is deemed better, the value range varies from industry to industry. For instance, the retail Industry has been found to have a higher ratio than the service industry.

A ratio equal to 1 reflects safe financial health and no immediate liquidity concerns, whereas a ratio that does not exceed 1 means that the company could potentially become insolvent within the year if it is not able to cover its debts with increased cash flow or through replenishing its capital. Therefore the higher the ratio, the better it is for the business. 

Although, a very high ratio might get negatively noticed by investors, for they may assume that the business is not optimizing its assets well or that it may be hoarding instead of paying its shareholders.
 

Significance of Current Ratio

The Current Ratio, if understood well enough, can prove to be a great tool for the business to manage its short-term obligations and meet its financial goals. Some of the most significant benefits are
 
●    It is one of the most important metrics to gauge a company’s liquidity. The greater the ratio, the better the health of the company’s finances.
●    It helps analyze the working capital of the business more effectively.
●    It tells the business how able it is to handle its creditors.
●    It helps in improving inventory storage.
●    It helps the decision-makers of a company with the best investment strategies.
●    It makes the company better at managing overhead expenses.
●    It makes the company more aware of its capability to achieve its sales goals.

Limitations of Current Ratio

Despite its importance in ascertaining a company’s financial steadiness, the Current Ratio has a few limitations:

●    It cannot be used as the only metric to understand the status of a company’s liquidity fully. When used in isolation from other factors, it can prove inexact or inaccurate.
●    This ratio only takes into account the quantitative aspect, while ignoring the qualitative ones.
●    In the case of seasonal sales, the ratio can show inconsistencies.
●    Easy to manipulate, it may not give the investors the real picture.
●    If the method of valuing inventory changes, so does the ratio. And this has very little to do with the actual financial status of the firm.
●    Often, it does not consider the recurrence of sales, thus proving to be inaccurate in its function of gauging financial health.
 

Conclusion

Overall, it is certain that the Current Ratio, when used along with other financial metrics, can track a company’s financial stability and security. It is useful for business owners, decision-makers, stakeholders, and prominent members of a business to understand the company’s finances, especially the short-term ones, successfully.