The current ratio is one of the most common measures of liquidity. It refers to the ratio of current assets to current liabilities.
The formula for current ratio is:
Current ratio = Current assets ÷ Current liabilities
Current assets include cash and cash equivalents, marketable securities, short-term receivables, inventories, and prepayments. Current liabilities include trade payables, current tax payable, accrued expenses, and other short-term obligations.
Current assets refer to cash and other resources that can be converted into cash in the short-term (within 1 year or the company's normal operating cycle, whichever is longer).
Current liabilities are obligations that are to be settled within 1 year or the normal operating cycle.
XYZ Company had the following figures extracted from its books of accounts.
| Current assets: | ||
| Cash and cash equivalents | $ 83,000 | |
| Marketable securities | 142,000 | |
| Trade and other receivables | 167,000 | |
| Inventories | 330,000 | |
| Prepayments | 60,000 | |
| Total current assets | $ 782,000 | |
| Non-current assets: | ||
| Long-term investments | $ 300,000 | |
| Fixed assets | 1,000,000 | |
| Total current assets | $ 1,300,000 | |
| TOTAL ASSETS | $ 2,082,000 | |
| Current liabilities | $ 337,000 |
| Non-current liabilities | 1,100,000 |
| Stockholders' equity | 645,000 |
| TOTAL LIABILITIES & EQUITY | $ 2,082,000 |
| Computation of current ratio: | ||
| Current ratio | = | Current assets ÷ Current liabilities |
| = | $782,000 ÷ $337,000 | |
| Current ratio | = | 2.32 |
If the current ratio computation results in an amount greater than 1, it means that the company has adequate current assets to settle its current liabilities. In the above example, XYZ Company has current assets 2.32 times larger than current liabilities. In other words, for every $1 of current liability, the company has $2.32 of current assets available to pay for it.
A high current ratio is generally considered a favorable sign for the company. Creditors are more willing to extend credit to those who can show that they have the resources to pay obligations. However, a current ratio that is too high might indicate that the company is missing out on more rewarding opportunities. Instead of keeping current assets (which are idle assets), the company could have invested in more productive assets such as long-term investments and plant assets.
The ideal current ratio is proportional to the operating cycle. Companies with shorter operating cycles, such as retail stores, can survive with a lower current ratio than, say for example, a ship-building company. The current ratio should be compared with standards -- which are often based on past performance, industry leaders, and industry average.
The current ratio is a very common financial ratio to measure liquidity.
Current ratio is equal to total current assets divided by total current liabilities.
A ratio greater than 1 means that the company has sufficient current assets to pay off short-term liabilities.
A high ratio implies that the company has a thick liquidity cushion.
