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Current Ratio – Meaning, Formula and How it works?

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What is Current Ratio? Meaning, Formula and How it works?
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As a stock market investor, you may have frequently come across the terms such as liquidity ratio, current ratio, and working capital ratio. Well, these are key financial ratios used by investors and analysts to analyze companies.

In this article let’s take a detailed look at:

What is Current Ratio?

The current ratio refers to a liquidity ratio that measures a business’s ability to pay short-range obligations or those payable within one year. The current-ratio is a very important ratio that helps investors and analysts to understand how a company can maximize the current assets in its balance sheet to pay off its current debt and other payment liabilities.

According to experts, while a current-ratio that is similar to the industry average or a tad higher is generally considered acceptable, a current ratio lower than the industry average shows a high risk of default. Further, if a company has a very high current-ratio in comparison with similar companies in the industry where it operates, it is an indicator that management may not be efficiently using its assets. The current ratio is referred to as “current” as it includes all current liabilities and current assets.

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How to calculate Current Ratio?

To calculate the Current-Ratio, one should compare the company’s current assets with its current liabilities. If you are wondering where to find all this information, don’t worry as everything is listed in the company’s balance sheet which can be found on a company’s website.

Current assets of a company include cash, prepaid expenses, accounts receivable, inventory, marketable securities, and other current assets (OCA) that are likely to be liquidated in short term (over a period of one year). Current liabilities include accounts payable, accrued liabilities, wages, any other liabilities payable in short term (over one year period), short-term debts, and taxes payable.

Current Ratio Formula

The formula for calculating the Current-Ratio is as follows:

Current Ratio =     Current Assets

                              Current Liabilities

Let’s understand this with the help of the below example:
XYZ company has current assets worth 5 crore rupees and current liabilities worth 4 crores. So when we divide its total current assets by current liabilities we can derive that its Current-Ratio is 1.25.

What is Ideal Current Ratio?

The historical performance of a company and the industry where it operates are two important factors to consider when looking at the ideal Current-Ratio. As a thumb rule, a Current Ratio of less than 1.00 means a company may struggle to meet its obligations in the short term. However, if the fall in the current-ratio below 1.00 is temporary due to the allocation of short-term cash resources for expansion of capacity or scaling up of business, there is nothing to worry about.

A Current Ratio of 1.50 or greater means adequate liquidity. A Current-Ratio of 1.50 or greater for a prolonged period also indicates that the cash reserves of the company are not efficiently utilized by the management.

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Key takeaways

Theoretically, a high Current Ratio, implies that a company is capable of paying its short-term obligations because it has a larger proportion of short-term asset value as compared to its short-term liabilities. However, a consistently high Current-Ratio, means that the company has adequate financial resources to remain solvent in the short term, it may also mean that the management of the company is not efficiently using its current assets.

While analysing a company for smart investment, one should always look at the Current Ratio in conjunction with other important ratios. Invest wisely after detailed research.

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