The current ratio refers to a company’s ability to use its current assets in order to pay off its short-term liabilities. This ratio is labeled as an efficiency and liquidity ratio and it is also an important measure of the latter mentioned liquidity as the short-term liabilities are due mostly within the next year.
Basically, a company or a firm doesn’t have all the time in the world to pay for these liabilities. If their current ratio is large enough, it means that they can easily round up some funds and pay their debts.
These current assets usually come in the form of marketable securities, cash, or cash equivalents and can be converted into cash in a short period of time – thus giving the company exactly what it needs, meaning funds.
The Basics of Current Ratio
The higher the current assets of a company are, the easier it will be for them to pay off their short-term liabilities without having to sell off on long-term – of course, because revenue does generate assets, right?
Naturally, the current ratio is of great help to creditors and investors as they will be able to better understand a company’s liquidity – specifically, how easy it is for that certain company to pay off its current debts without having to take any desperate measures.
The Formula of Current Ratio
The formula is as easy as it can get – you get your company’s current ratio by dividing its current assets by its current liabilities. It was kind of obvious, right? As most ratios out there, the current ratio is always stated in a numeric format, and not in a decimal one.
While most of the things that are related to financial ratio can be specified as the owner desires on the balance sheet, the GAAP requires that the long-term and current liabilities are placed separately on it.
Naturally, this is so that creditors and investors would have an easier time calculating important ratios – the one that they’re after – rather than diving into more complex calculus. Moreover, on the U.S. financial statements, the current liabilities are always reported before the long-term ones, as they are more important and require earlier paying off.
Therefore, we’ve learned so far that the current ratio tells of the company’s current debt in regard to current assets. The ratio that comes as a result of the previously mentioned formula – which is in numeric format, remember – is intuitive.
For example, a current ratio of 4 means that your company has enough funds to pay its current liabilities four times – which means you are doing just great!
Of course, a higher current ratio is clearly more favorable to you, because this means that your company is able to handle its debts without any problems. On the other side, a low current ratio means that the company will have to sell off fixed assets in order to pay off its debts.
Basically, this means it is not making enough money via its operations and it is, therefore, losing money – poor collections of accounts receivable are usually the main cause that leads to this aspect.