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Current Ratio

The current ratio is a liquidity ratio that evaluates a company’s ability to pay short-term and long-term commitments. Current assets are compared to current liabilities to calculate the current ratio. Inventory accounts receivables and any other asset that can be converted into cash within a year can be included in current assets. Current liabilities include taxes payable, wages and the part of long-term debt which are meant to be paid within a year.

What is current ratio formula?

Current Ratio = Current Assets / Current Liabilities

A current ratio that is in parity with the industry average or a bit higher is generally considered sound. A current ratio that is lesser than the industry average may indicate a higher risk of distress or default. In the same way, if a company displays a very high current ratio compared to their peer group, it can be considered as an indication that there is an inefficient use of assets by the management.

Why current ratio is important?

GAAP has layed down guidelines which require companies to split current and long-term assets and liabilities on the balance sheet. This separation lets investors and creditors to evaluate important ratios like the current ratio. On U.S. financial statements, current accounts are always shown before long-term accounts.

How to interpret current ratio?

The current ratio acts like an assistant to investors and creditors to evaluate the liquidity of a company and how comfortably that company can pay off its current liabilities. Current ratio expresses a firm’s current debt when compared to current assets. So a current ratio of 4 would mean that the company has 4 times more current assets than current liabilities.

Current ratio that is higher is anytime considered more favourable than a lower current ratio as it suggests that the company can more easily make current debt payments.

A ratio under 1 suggests that the debts a company is supposed to pay in within a year are greater than its assets (either cash or expected to be converted to cash within a year or less.) A current ratio less than one would trouble a company if it has a much higher receivables turnover than payables turnover. For example, the collection from consumers of retail companies are very quick but they have a long time to pay their suppliers. Because of this imbalance, a current ratio below 1 is normal within the industry group.

The current ratio for three companies – Royal Furnitures, Star Automobiles and Crystal Wholesale – are calculated as follows for the fiscal year ended 2017:

CompanyCurrent AssetsCurrent LiabilitiesCurrent Ratio
Royal Furnitures$132.24 million$94.25 million132.24/94.25=1.40
Star Automobiles$14.32 million$15.2 million14.32/15.2=0.94
Cystal Wholesale$21.32 million$21.5 million21.32/21.5=0.99

Limitations of ‘Current Ratio’ for every $1 of current debt, Crystal Wh. had $.99 cents available to pay for the debt at the time this table was prepared. Similarly, Star Automobiles had $.94 cents available in current assets for each dollar of current debt. Royal Furniture had more than enough to cover its current liabilities if they were all theoretically due immediately and all current assets could be turned into cash.

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