Current Ratio

Lesson

The Current Ratio is a financial metric used to evaluate a company's short-term liquidity position by comparing its current assets to its current liabilities. It is an essential tool for investors and analysts to assess a company's ability to meet its short-term obligations. A higher current ratio indicates better liquidity, while a lower ratio may signal potential financial distress.

Practice Question #1

What is the formula for calculating the current ratio?

Terms

Current Ratio:

A financial metric measuring a company's ability to pay its short-term liabilities with its assets.

Current Assets:

Assets expected to be converted into cash or used up within one year, such as cash, accounts receivable, and inventory.

Current Liabilities:

Obligations expected to be settled within one year, such as accounts payable, short-term debt, and accrued expenses.

Working Capital:

The difference between a company's current assets and current liabilities.

Practice Question #2

Which of the following would increase a company's current ratio?

Do Not Confuse With

Quick Ratio:

A liquidity ratio similar to the current ratio but excludes inventory from current assets, making it a more conservative measure of a company's short-term liquidity.

Acid-Test Ratio:

A more stringent liquidity ratio that excludes inventory from current assets.

Practice Question #3

A company has a current ratio of 0.8. What does this indicate about the company's liquidity position?

Historical Example

In the early 2000s, a major telecommunications company faced financial distress due to a low current ratio of 0.5, indicating that it had only half the current assets needed to cover its current liabilities. This situation led to the company's bankruptcy and eventual liquidation, as it could not meet its short-term obligations.

Real-World Example

A small retail business has $100,000 in current assets and $50,000 in current liabilities. Its current ratio is 2.0 ($100,000 / $50,000), indicating that it has twice the amount of current assets needed to cover its current liabilities and is in a strong liquidity position.

Rhyme

Current ratio, a measure so fine, compares assets and liabilities in line. Higher the number, better the state, for a company to meet obligations, it won't be late.

Formulas to Remember

Current Ratio = Current Assets / Current Liabilities

Formula Examples

Company ABC has the following financial information: Current Assets: $500,000 Current Liabilities: $250,000 Current Ratio = Current Assets / Current Liabilities Current Ratio = $500,000 / $250,000 Current Ratio = 2

Pitfalls to Remember

High Current Ratio:

A high current ratio may indicate that a company is not efficiently using its assets to generate revenue. It could also mean that the company is holding too much cash or has a large amount of receivables that may not be collected.

Low Current Ratio:

A low current ratio may indicate liquidity problems and an inability to meet short-term obligations. However, it could also mean that the company operates in an industry with low working capital requirements or has a strong cash flow.