The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-term obligations that are due within a year. The ratio considers the weight of total current assets versus total current liabilities. It indicates the financial health of a company and how it can maximize the liquidity of its current assets to settle debt and payables. The current ratio formula (below) can be used to easily measure a company’s liquidity.
Current Ratio = Current Assets / Current Liabilities
Example of the Current Ratio Formula
If a business holds:
Cash = $15 million
Marketable securities = $20 million
Inventory = $25 million
Short-term debt = $15 million
Accounts payables = $15 million
Current assets = 15 + 20 + 25 = 60 million
Current liabilities = 15 + 15 = 30 million
Current ratio = 60 million / 30 million = 2.0x
The business currently has a current ratio of 2, meaning it can easily settle each dollar on loan or accounts payable twice. A rate of more than 1 suggests financial well-being for the company. There is no upper-end on what is “too much,” as it can be very dependent on the industry, however, a very high current ratio may indicate that a company is leaving excess cash unused rather than investing in growing its business.
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Current Ratio Formula – What are Current Assets?
Current assets are resources that can quickly be converted into cash within a year’s time or less. They include the following:
Cash – Legal tender bills, coins, undeposited checks from customers, checking and savings accounts, petty cash
Cash equivalents – Corporate or government securities with 90 days or less maturity
Marketable securities – Common stock, preferred stock, government and corporate bonds with a maturity date of 1 year or less
Accounts receivable – Money owed to the company by customers and that is due within a year – This net value should be after deducting an allowance for doubtful accounts (bad credit)
This current ratio is classed with several other financial metrics known as liquidity ratios. These ratios all assess the operations of a company in terms of how financially solid the company is in relation to its outstanding debt. Knowing the current ratio is vital in decision-making for investors, creditors, and suppliers of a company. The current ratio is an important tool in assessing the viability of their business interest.
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