Current Ratio

The current ratio (CR) is one of the most commonly applied financial tools of evaluation in the assessment of the liquidity of a firm. It gives a reflection of whether a company is able to pay its short-term liabilities from the available short-term assets. In this post, we are going to explain in detail what the CurrentRatio is, current ratio formula, and give examples for calculation. We’ll also look at the current ratio vs quick ratio to help you understand these two important liquidity ratios.

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    What is the Current Ratio?

    It is a financial tool that shows the relationship between current assets and current liabilities of a company. It provides insight into whether a firm has adequate short-term assets to cover or pay off its short-term debt. Any CurrentRatio higher than 1 suggest that the firm can meet all its obligations while a CurrentRatio of less than 1 may imply a financial period of difficulty.

    Formula for Calculation

    The calculation formula for the Current Ratio is given below:

    CurrentRatio = Current Assets/Current Liabilities​

    Current Assets: The Current Assets are those assets that constitute cash, accounts receivable, inventory, and other assets that are liquidated within a year.

    Current Liabilities: It represents accounts payable, short-term loans, and the like due within a year.

    How to Calculate Current Ratio

    In this section, a practical example is used to explain how to calculate the CurrentRatio.

    Example 1:

    A company has current assets valued at $500,000 and current liabilities amounting to $250,000.

    CurrentRatio = 500,000/250,000 = 2.0

    Hence, in this case, this company’s CurrentRatio is at 2.0, which further signifies that current assets are two times larger than the current liabilities of the organization. Therefore, it can be proved that the liquidity position of the organization is sound.

    Example 2:

    A company has current assets amounting to $120,000 and has current liabilities of $150,000.

    Using the same formula:

    CurrentRatio = 120,000/150,000 = 0.8

    In this scenario too, the value of the CR is less than 1.0. This indicates that this organization might face hindrances in the process of confronting its short-term obligations.

    Current Ratio vs Quick Ratio

    While the current ratios includes all the current assets, the quick ratio- includes readily available current assets less inventories. The quick ratio is a more conservative method of testing liquidity, as it only considers the most liquid types of current assets. It assumes that inventory cannot easily be sold for cash.

    Quick Ratio Formula:

    Quick Ratio = Current Assets/ Current Liabilities – Inventory/ Current Liabilities

    Overall, this quick ratio is usually lower than the CurrentRatio as a result of the assets that it excludes, such as inventory. It is a better measure for those companies whose inventories are not as liquid in that they may take longer to sell.

    Why Is the CurrentRatio Important?

    It is one of the most important indicators regarding the assessment of the financial health of a company. Investors, creditors, and management could use it as a base for measuring liquidity risk and making their decisions accordingly. A too-high ratio would then show that the company is not using its assets efficiently, and too low could show financial distress.

    How FastLane HR Can Help

    It is vital to understand the calculation for the CurrentRatio and the difference between the current ratio vs. quick ratio in determining the liquidity position of a business. From a CurrentRatio formula, it is easy to tell whether or not the business can pay its short-run liabilities. Ongoing monitoring of the ratio supports financial stability that then may inform effective decision-making.

    With this simple yet powerful tool, you can make far more informed judgments about a company’s short-term financial health.

    Always keep in touch with FastLane HR  to know about the professional tips of finance management and accounting.