Current Ratio: Definition, Formula, Example & Interpretation

Understand

In financial analysis, current ratio or working capital ratio is a liquidity ratio that measures company’s ability to pay back its current liabilities with its current assets. In simple, if a company has enough current asset in relation to current liabilities then it provides assurance that obligation coming due will be paid. The formula to calculate the ratio is:

Current ratio = Current Asset / Current Liabilities

How it works (Example)

The current ratio is used to indicate the company’s liquidity position by measuring the proportion of current assets to current liabilities. For example, you want to invest in a company ABC, the abstract from the balance sheet of the company for the year ended 2018 is hereunder:

Current Assets

Account Receivable = 12,000

Stock (Inventory) = 9,000

Cash = 5,000

Total Current Assets = 26,000

Current Liabilities

Account Payable (Creditors) = 7,000

Short Term Loan Payable = 8,000

Current Portion of Long Term Loan = 4,000

Total Current Liabilities = 19,000

The current ratio of the company ABC can be calculated as:

Current Ratio = Current Asset / Current Liabilities = 26,000/19,000 = 1.368

Current Ratio Interpretation

This means that at the end of 2018, company ABC has 1.368 dollars in current assets against every dollar of current liabilities, which depicts company’s ability to pay back its current liabilities efficiently with its current assets. If the ratio is less than one then the company may have problems while paying back its liabilities, although it is not an alarming sign for an investor but should concern the management.

Limitations

Although all financial ratios are a perfect measure to gauge the financial health of a company but one who evaluate the company for investment, should also consider their limitations like in the case of the current ratio:

  • It is wise to compare the current ratio of two different companies within same industry because business operations differentiate substantially across industries.
  • To determine exact liquidity position, the ratio is not precisely like quick ratio because it includes all those assets which may not easily liquidate like slow moving inventory etc.
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