Alternative names: working capital ratio
The current ratio is a company liquidity measurement that indicates the company ability to meet its short term debt obligations with its short term assets. The current ratio is an important measurement of liquidity as it focusing on the company liabilities that are due within the next year. The current ratio also might be used as efficiency measurement as it indicate the ability of a company to maximise current assets on its balance sheet to cover its current liabilities.
The formula for calculating current ratio is derived by dividing current assets by current liabilities.
Current ratio = Current Assets / Current Liabilities
The current assets and current liabilities can be found on the balance sheet of the company financial report.
If a business firm has $500,000 in current assets and $200,000 in current liabilities, the calculation is $500,000/$200,000 = 2.5. In this example the current ratio of 2.5 means that the business can pay its current liabilities from its current assets two and a half times over.
The current ratio is a tool for investors to estimate the liquidity and solvency of a company in the short term. Especially if it is compared agains the historical values for the company as well as compared with its industry peers. If a company has current ratio of less than one its an indication that the company does not have enough assets to meet ist short term obligation and it might not stay solvent. We have to keep in mid that when calculating the current ratio not all of the current assets might we as liquid as some of them might not be able to easily be used for liabilities repayments. The quick ratio is more useful for this type of measurements.
As a rule of thumb, acceptable current ratio for a company is 2. This is a relatively safe financial position for most businesses. Current ratio can vary from industry to industry but generally a higher current ratio is considered as better than lower. For some industrial companies, 1.5 may be an acceptable current ratio. Excessively large current ratios might not always be a good thing though as it might be an indicator for an investor that the company is not efficiently using its current assets and short term financing to grow its business. When assessing the current ratio of a company to determinate liquidity of a company it is important to also take into account the operating cashflow of the company. If a company has good strong operating cashflow it might be able to sustain a lower current ratio.