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Current Ratio

The current ratio is a business accounting formula that measures a company's ability to pay its short-term obligations, namely those due within a year. The mathematical formula is expressed as:

Current Ratio = Current Assets/Current Liabilities

Current assets include cash and cash equivalents, securities that can be sold quickly, short-term investments, accounts receivable, short-term notes receivable, inventories and supplies, and prepayments. Current liabilities, which are obligations that must be paid within the next 12 months, include accounts payable, salaries and wages, taxes, and accrued expenses.

In general, the higher the current ratio, the better. A current ratio of 1.0 or more means that current assets are greater than current liabilities and the company should not face any liquidity issues. A current ratio below 1.0 means that current liabilities are more than current assets, which may indicate liquidity problems.

For example, a company has total current assets of US$3 million and current liabilities of US$2 million. Its current ratio would be 1.5 (US$3 million/US$2 million = 1.5), which would indicate the company is in fairly good shape. However, if its current assets totaled US$2 million and it had US$3 million in current liabilities, its current ratio would be 0.66, which could be a sign of trouble ahead.

Differences From Quick Ratio

The current ratio is different than the quick ratio, which measures only the most liquid current assets to the most immediate liabilities. Notably, the quick ratio doesn't include inventories, supplies and prepaid expenses.

Current ratios can vary sharply depending on the industry. For example, retail companies generally have very high current ratios because so much of their assets include inventories. Service providers, by contrast, generally have low current ratios because they usually don't have a lot of assets.

However, there is a limit to the extent to which higher current ratios are a good thing. A high current ratio may indicate that some assets are being underutilised, which could have a negative bearing on the company's profitability.((Retrieved 5 March 2019 https://accountingexplained.com/financial/ratios/current-ratio))

Summary

The current ratio measures the ability of a company to meet its obligations over the next year. The ratio is calculated by dividing the company's current assets by its current liabilities. Generally, the higher the current ratio, the better, with a ratio greater than 1.0 meaning that the company has more than enough to cover its liabilities.

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