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A liquidity ratio called the current ratio assesses a company's capacity to settle short-term debts or those that are due within a year. It explains to investors and analysts how a business can use its present assets to the fullest extent possible to pay down its current liabilities and other payables.
This ratio takes a broader perspective of liquidity by incorporating such assets as inventories in its computation, in contrast to the Quick Ratio and the more constrained Cash Coverage Ratio that only examines easily "cashable" or quick assets.
The current ratio enables investors to compare a company's financial performance to that of its peers and competitors on an equal footing and to learn more about a company's ability to pay down short-term debt with current assets.
Since there would be no short-term assets left over once all short-term debts were paid off, a ratio value of 1:1 (or 1) is generally regarded as the absolute minimum for an acceptable level of liquidity.
Formula
Simply dividing a company's current assets by its current liabilities will get this liquidity ratio.Current Ratio = Current Assets / Current Liabilities
Cash, accounts receivable, inventory, and other current assets that are anticipated to be liquidated or converted into cash in less than a year are all examples of current assets that are included on a company's balance sheet.
Accounts payable, wages, taxes due, short-term loans, and the current portion of long-term debt are all examples of current liabilities.
Understanding Current Ratio
A corporation can more readily satisfy its debt repayment obligations if its current asset ratio is larger, which is advantageous. A ratio of 2 indicates that a company has assets that are twice as large as liabilities.If all of a company's short-term obligations were to become due at once, a company with a current ratio of less than 1.00 frequently wouldn't have the cash on hand to cover them, whereas a company with a current ratio over 1.00 would likely have the financial resources to meet all of its short-term obligations.
Things to Consider
The current ratio, however, is typically not an accurate reflection of a company's short-term liquidity or longer-term solvency since it just provides a snapshot of the situation at any given time.As an illustration, a typical cycle for the company's payment and collection procedures could result in a high current ratio as payments are received but a low current ratio as those collections wane. The corporation may not be able to pay off all of its present debts, as shown by the current ratio calculation, but this does not necessarily suggest that it won't be able to when the payments are due.
It's crucial to keep in mind that if a company's assets are heavily stocked with inventory, the ratio value may be off. The company's ability to settle its debts shortly, should the need arise unexpectedly, would not be accurately reflected by this position because inventory is less liquid than other forms of assets.
A high ratio—more than 2.00, for instance—may mean that the business can pay its present obligations twice over, but it could also mean that it is not managing its working capital, procuring financing effectively, or utilizing its current assets to its full potential.
