Current Ratio – Formula and Explanation

What is the Current Ratio?

Current ratio, also known as the working capital ratio, measures the potential of a business on meeting its short-term obligations that are due within a year. The ratio considers the weight of the total current assets versus the total current liabilities. It indicates the health of the company, and how it can maximize on the liquidity of its current assets to settle debt and payables.

 

Current Ratio formula

The Current Ratio formulas is as follows:

 

Current Ratio = Current Assets / Current Liabilities

 

Example of the Current Ratio

If a business has:

  • 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

 

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 this can be very dependent on the industry.

 

What are Current Assets?

Current assets are resources that can quickly be converted into cash within a years time or less. This includes:

  • Cash – legal tender bills, coins, un-deposited 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 that are due within a year. This net value should be after deducting an allowance for doubtful accounts (bad credit)
  • Notes receivable maturing within a year
  • Other receivables – such as insurance claims, employee cash advances, income tax refunds
  • Inventory – raw materials, work-in-process, finished goods, manufacturing/packaging supplies
  • Office supplies
  • Prepaid expenses – unexpired insurance premiums, advance payments on future purchases

 

What are Current Liabilities?

Current liabilities are business obligations owed to suppliers and creditors, and other payments that are due within a year’s time. This includes:

  • Notes payable – principal portion of loan that will become due within one year
  • Accounts payable or Trade payable – credit resulting from the purchase of merchandise, raw materials, supplies, or usage of services and utilities.
  • Accrued expenses – payroll taxes payable, income taxes payable, interest payable

 

What is the importance of using Current ratio?

This ratio is classed with several others known as ‘liquidity ratios.’ These ratios all assess the operations of a company, and how readily it will be able to save itself when debt is called. Knowing the ratio is vital in decision-making for investors, creditors, and suppliers of a company. When it comes to these parties, the current ratio is an important tool in assessing the viability of their business interest.

 

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